2.1.2 - Inflation

Question 1

What is inflation?

Answer 1

The rate of change in the average price level over time,

or

The sustained increase in the cost of living/fall in the purchasing power of money.

Question 2

What is deflation?

Answer 2

A decrease in the general price level. For deflation to occur, the average level of prices must decrease.

Also, if the rate of inflation falls from 2.7% to 2.5% this means that prices are increasing at a slower rate.

Question 3

Name one problem of deflation

Answer 3

• Consumption decreases due to consumer behaviour changing as they wait for prices to decrease again. This meas that firms are holding stock and producers don’t need as much stock. Eventually, they may let people go.
• Consumer behaviour changes and they start to save/hoard money. Consumers don’t need to borrow money.

Question 4

What is disinflation?

Answer 4

When the inflation rate is postive but still falling. Prices still rise but at a lower rate.

Question 5

How do commodities (food and oil etc) affect the price level?

Answer 5

Food and oil have a large percentage of UK imports. Also, as they are weighted they have a significant effect on the consumer prices index (CPI). Many of the products bought in the are inelastic so a global rise in commodities would feed through to UK inflation.

Question 6

Name 2 impacts of inflation on firms

Answer 6

• They have to change their prices due to inflation
• Workers want higher wages
• Less competition globally due to higher inflation rates in UK
• Real debt levels fall
• Less confidence to invest
• Inflation could be a sign of rising demand
• Firms face rising prices and consumers have low demand

Question 7

How do governments increase the money supply?

Answer 7

• Printing notes
• Quantative easing
• Reduce the deposit holdings of banks which allows them to lend more
• Bank of England can buy bonds off financial institutions creating liquidity

Question 8

What is cost-push inflation?

Answer 8

This is when the cost of things are going up due to lack of supply.

supply decreases = demand increases

Question 9

What are the 3 types of inflation

Answer 9

• Demand-pull
• Cost-push
• Growth of the money supply

Question 10

Name 3 general effects of inflation on consumers

Answer 10

• Consumers have less purchasing power
• Consumers on fixed incomes lose out because their real income falls
• Price increases leads to higher wage demands as people try to maintain their living standards

Question 11

What is the CPI?

Answer 11

One of the preffered methods to measure inflation.

It’s a method that records the price of around 700 goods (most likely within a financial year). Then different items are weighted according to their relative importance within society. For example, petrol and commodities compared to thermals.

Question 12

What type of inflation is likely to be caused by consumer credit?

Answer 12

A. Cost-push inflation

B. Demand-pull inflation

Question 13

Why might savers suffer in the times of high inflation?

Answer 13

Inflation is the average increase of The rate of change in the average price level over time. This means that goods and services will increase in price. This means that the money saved in the savers’ banks will have less purchasing power. This means that the money they have saved will be less goods and services.

Question 14

What is demand-pull inflation?

Answer 14

Demand-pull inflation is caused by an EXCESSIVE demand in the economy for goods and services.

*Remember aggregate demand formula

Question 15

What is cost-push inflation?

Answer 15

This type of inflation happens when firms respond to risin costs of production. For example, when the price of oil increases increases prices of products will consequently increase prices of goods and services which contain oil so rational firms (firms which are profit-motivated). This means that consumers will face the prices which are rising.

Question 16

What are interest rates?

Answer 16

The cost of borrowing AND the reward of saving.

Question 17

What are real interest rates?

Answer 17

Interest rates which are adjusted for inflation.

Inflation % VS Interest Rate % = Real Interest Rate.

Question 18

What are the measures of inflation?

Answer 18

• The consumer price index

- The retail price index

Question 19

What is the preferred measure of inflation and what does this measure form?

Answer 19

The preferred one is the consumer price index, and this is the measure which forms the Bank of England target

Question 20

What is so special about both the measures?

Answer 20

Both the measures are weighted

Question 21

What does it mean when one of the products on the basket of goods are weighted?

Answer 21

This means that these goods measured to “heavier” than other goods due to their relative importance inside society.

For example, petrol VS socks

Question 22

What is the retail price index?

Answer 22

The Retail Price Index (RPI) is an older measurement of inflation that is still published because it is used to calculate cost of living and wage escalation; however, it is not considered an official inflation rate by the government.

Question 23

Name 2 causes of demand-pull inflation

Answer 23

• Reduced taxation
• Lower interest rates
• A general rise in consumer spending
• Improved availability of credit
• A weak exchange rate
• Fast growth in other countries
• General rise in confidence/expectations of future growth
• Certainty

Question 24

Explain how reduced taxation has an effect on demand-pull inflation.

Answer 24

With lower tax rates, the percentage of money consumers have to pay to the government decreases which means that they have more disposable income to spend on goods and services.

Question 25

Explain how lower interest rates has an effect on demand-pull inflation

Answer 25

Interest rates are lower which means that borrowing is more attractive (as less interest has to be paid back) and saving is less rewarding (which means that consumers are less likely to save their money) and therefore consumers will spend more.

Question 26

Draw/Describe a demand-pull inflation diagram

Answer 26

- Y axis labelled as "Price Level" - X axis labelled as "Real National Output" - Supply line labelled as SRAS - Demand line labelled as "AD", "AD1", "AD2"" etc - Equilibrium points for where SRAS and AD/AD1 meet and then dottted lines from the equilibrium points to the axis *page 228 for an example

Question 27

What causes AD to outwards to AD(X) ?

Answer 27

When one of the factors affecting demand-pull inflation (for example a cut in interest rates making borrowing more attractive because less interest is paid back) so consumer will be inclined to spend more.

Question 28

Name 2 causes of cost-push inflation

Answer 28

- Wage increases - Higher raw materials cost - Higher taxes - Higher import prices - Natural disasters

Question 29

Explain how higher import prices have an effect on cost-push inflation

Answer 29

With the acronym of WPIDEC, a weaker exchange rate or rising prices abroad (another country has higher costs so they increase the price for us for them to still make a profit) means that imported components feed through to higher costs of production.

Question 30

Explain how wages have an effect on cost-push inflation.

Answer 30

For a lot of firms wages will be their highest cost of production. If prices for goods and services are increasing it's likely that the employees will demand higher wages in order to maintain their real income. If the higher wage costs are reflected in higher prices then this could result in a wage-price spiral.

Question 31

Draw/Describe a cost-push inflation diagram.

Answer 31

- Y axis labelled as "Price Level" - X axis labelled as "Real National Output" - Supply line labelled as "SRAS", "SRAS1", "SRAS2" - Demand line labelled as "AD" - Equilibrium points for where SRAS/SRAS1 and AD meet and then dotted lines from the equilibrium points to the axis

Question 32

What causes SRAS to shift inwards to SRAS1 on the cost-push inflation diagram?

Answer 32

Due to one of the causes of cost-push inflation occurring. For example, if there is an increase of wage rates there'll be firms increasing their costs of production because it'll cost a firm more in order to sell X amount of supply. Due to less supply, firms may have to increase prices to sustain the profit they made before so P jumps up to P2.

Question 33

What is the money supply (growth of the money supply) ?

Answer 33

The money supply is a measure of the amount or stock of money in the economy. There are different definitions: - M0 is known as narrow money and includes notes and coins in circulation and some other liquid assets - Broad money, M4 includes a wider definition of money including M0, bank account deposits and other liquid assets

Question 34

What is quantitative easing?

Answer 34

When the recession began in 2008 in the UK, the Bank of England would have been expected to cut interest rates in order to stimulate economic activity. However with interest rates at 0.5%, they had very little downwards movement to manipulate the economy with. In addition banks were very nervous about lending money to firms and individuals, so the Bank of England sought to boost the funds available for lending to businesses and firms. In total, £375bn has been raised in QE.

Question 35

When does deflation tend to occur?

Answer 35

It tends to occur in periods of very low, or stagnant growth.

Question 36

Name 2 demand-side causes of deflation.

Answer 36

- A deep fall in AD causing a persistent recession/depression - Large negative output gap - a high level of spare capacity

Question 37

What is aggregate demand?

Answer 37

Aggregate demand is the total amount of goods and services demanded in the economy at a given time and price level. Aggregate demand is the sum of consumption expenditure, investment expenditure, government expenditure and net exports

Question 38

Draw/Describe a deflation diagram.

Answer 38

- Y axis labelled as "General Price Level" - X axis labelled as "Real GDP" - Supply line labelled as "AS", "AS1" - Demand line labelled as "AD", "AD1" - Equilibrium point where AS and AD going back to the axis as GPL and Y

Question 39

Name 2 supply-side causes of deflation

Answer 39

- Improved productivity - Technological advances - Significant fall in wage rates - High exchange rates causing import prices to fall

Question 40

Explain how a deep fall in aggregate demand has an effect on deflation.

Answer 40

Since aggregate demand is made of consumption, investment, government spending and net trade. Assuming there is a great fall in consumption, this will lower prices and lead to lower production levels, which, in turn, leads to lower wages, which leads to lower demand by businesses and consumers, which lead to further decreases in prices.

Question 41

Explain how a large negative output gap has an effect on deflation.

Answer 41

A large negative output gap means that the difference between the actual level of GDP and its estimated potential level is negative. GDP (this is the value of output in an economy) going down will result in a decrease in price (as firms know price has a link with value).

Question 42

Explain how wage rates decreasing will cause deflation.

Answer 42

If wage rates decrease and prices are too high, workers will demand higher wages. However, if firms want to keep their employees (in short keep expenditure low) they'll have to decrease prices.

Question 43

Explain how better technology affects deflation.

Answer 43

If new machinery is released and allows firms to be able to make products for a cheaper price, this will be then mirrored in the price of the particular good or service.

Question 44

Name 2 limitations of using CPI as a measure of inflation

Answer 44

- The CPI isn't fully representative - Spending patterns - Housing costs - Changing quality of goods and services - New products

Question 45

Explain how the consumer price index (CPI) not being fully representative is a limitation.

Answer 45

It won't be representative for households which are 'different'. For example, fourteen percent of the CPI is dedicated to motoring costs and this is inapplicable for households that don't own vehicles.

Question 46

Explain how changing quality in goods and services is a limitation for the consumer price index (CPI).

Answer 46

Although a price of a good or service may increase may rise, this may also be accompanied with a by an improvement of that particular good or service.

Question 47

What's the formula to calculate the index for inflation.

Answer 47

price value of year --------------------------- X100 PV of base year