2.1.2 Inflation

Question 1

Inflation

Answer 1

The sustained rise in the average price level of goods or services in an economy over a period of time

This causes a fall in the value (purchasing power) of money.

Question 2

Inflation causes a fall in the value of money. What does this mean?

Answer 2

• A fixed amount of money buys less than before.
• The purchasing power of money has fallen.

Question 3

Deflation

Answer 3

Deflation is a sustained period when the general price level for goods and services is falling.

Question 4

Disinflation

Answer 4

Disinflation is a fall in the rate of inflation but not sufficient to bring about price deflation. During a period of disinflation, consumer prices are still rising but at a slower rate.
(When the rate of inflation is slowing down – prices are still rising, but at a lower speed.)

Question 5

Hyperinflation

Answer 5

Hyper-inflation is a phase of extremely rapid inflation nearly always the result of mass money printing by the government with money as an asset ending up as worthless.

Question 6

What are the two measurements of inflation?

Answer 6

• RPI
• CPI

Question 7

Retail Price Index (RPI)

Answer 7

An older measurement of inflation and is used to calculate the cost of living. However, it is not considered to be an official inflation rate by the government. RPI has largely been replaced by the CPI.

Question 8

How is RPI calculated?

Answer 8

A survey called the Living Costs and Food Survey is done, including around 6000 households, to find out what people spend their money on. This survey also shows what proportion of income is spent on these items. This is used to work out the relative weighting for each item. | E.g. If 20% of income is spent on transport, then a 20% weighting will be given to transport.

RPI is calculated based on the changes in price of around 700 of the most commonly used goods/services (referred to as the ‘basket of goods’).

These items are chosen based on a living costs and food survey. What is in the basket changes over time, because technology, trends and tastes change – which ensures the basket always reflects what the average household might spend its money on.

The price changes are multiplied by the weighting given to it (based on the proportion of income spent on these items). The price change is then converted to an index number, so inflation is the percentage change of the index number over time. E.g. if the index number rises from 100 to 201, then inflation is 2%.

Question 9

How is Consumer Price Index (CPI) calculated?

Answer 9

1. Selection of the Basket of Goods and Services
2. Determination of the weights based on spending patterns
3. Price data collection including retail and online prices
4. Calculation of a price index using weights

Question 10

Differences between RPI and CPI

Answer 10

The differences mean that the CPI tends to be lower than the RPI – with the exception of when interest rates are low. However, they both tend to follow the same long-term trend.

The CPI is the official measure of inflation in the UK. Many other countries collect data on inflation in a similar way to CPI so it is often used for international comparisons.

Question 11

Limitations of RPI and CPI

Answer 11

The RPI and CPI can be really useful, but they also have their limitations:
1) The RPI excludes all households in the top 4% of income. The CPI covers a broader range of the population but doesn’t include mortgage interest payments or council tax.

2) The information given by households in the Living Costs and Food Survey can be inaccurate.

3) The basket of goods only changes once a year – so it might miss out short-term changes in spending habits.

Question 12

How are CPI and RPI used to measure changes in the UK’s international competitiveness?

Answer 12

• If the rate of inflation measured by the CPI is higher in the UK than in the other countries it trades with, then UK goods become less price competitive as they’ll cost more for other countries to buy.
• So exports will fall, and imports will increase (as they are made cheaper by domestic inflation).

Question 13

How are CPI and RPI used to help to determine wages and state benefits?

Answer 13

• Employers and trade unions use them as a starting point in wage negotiations.
• The government uses them to decide on increases in state pensions, and other welfare benefits.
• Some benefits are index-linked and will rise automatically each year by the same percentage as the chosen index.

Question 14

Two types of inflation:

Answer 14

• Demand-pull inflation
• Cost-push inflation

Question 15

Demand-pull inflation

Answer 15

Inflation caused by a rapid growth in aggregate demand

Question 16

How does demand-pull inflation change the supply/demand curve?

Answer 16

This growth in demand shifts the AD curve to the right (AD to AD1), which allows sellers to raise prices.

Question 17

Causes of demand-pull inflation

Answer 17

• High consumer spending or high demand for exports
• The money supply growing faster than output
• Bottleneck shortages
• Wage price spiral

Question 18

Cost-push inflation

Answer 18

Inflation caused by businesses increasing the prices of their goods and servicesto protect their margins

Question 19

How does cost-push inflation change the supply/demand curve?

Answer 19

Rising costs of inputs to production force producers to pass on the higher costs to consumers in the form of higher prices, which causes the aggregate supply curve to shift to the left (from AS to AS1).

Question 20

Causes of cost-push inflation

Answer 20

• A rise in wages above any increase in productivity
• A rise in the cost of imported raw materials
• A rise in indirect taxes

Question 21

How can inflation be impacted by changes to the money supply?

Answer 21

If the central bank lowers the base rate, there is likely to be increased borrowing by firms and consumers:
- This will result in an increase in consumption and investment.
- It is likely to lead to a form of demand-pull inflation.

The central bank can also increase the money supply through quantitative easing:
- This will result in increased liquidity and lower interest rates.
- It is likely to lead to a form of demand-pull inflation.

Question 22

Costs and consequences of inflation

Answer 22

• Standard of living for those on fixed incomes fall.
• A country’s competitiveness will be reduced (as exports will cost more to buy and import will be cheaper). If exports fall and imports rise, then this could create a deficit in the balance of payments and increase unemployment.
• Discourages savings because the value of savings falls. This makes it more attractive to spend (creating demand-pull inflation) before prices rise further.
• A reluctance to save creates a shortage of funds for borrowing and investment, which means that it’s harder for firms to make improvements, e.g. buy new machinery. If interest rates go up to reduce inflation, this will also reduce investment.
• Creates a reduction in savings
• Hyperinflation
• Wage price spiral : Workers demand higher wages to keep up with rising prices, which can lead businesses to raise prices further.
  -Menu Costs: Businesses must frequently update prices on menus, labels, websites, etc., leading to operational costs.
• Shoe Leather Costs: Consumers make more frequent trips to the bank or make quicker spending decisions to avoid holding devalued cash.
• Exchange Rate Volatility: inflation can weaken a country’s currency, making imports more expensive and fueling further inflation.
• Capital flight

Question 23

Some potential benefits of inflation

Answer 23

Reduces Real Value of Debt: Inflation can help borrowers repay loans more easily with “cheaper” money.
Encourages Spending and Investment : If people expect prices to rise, they may spend or invest sooner, boosting economic activity.
Wage Growth: In a healthy economy, moderate inflation is often accompanied by rising wages.
Allows for Real Wage Adjustments: Employers can give smaller nominal raises (below inflation), effectively cutting real wages without reducing morale.

Question 24

Bank of England target for inflation

Answer 24

In the UK, the Bank of England and the government consider low and stable inflation (up to 2%) to be acceptable. Excessive inflation (above 2%) is undesirable and can cause a variety of problems.

The government uses a combination of monetary policy, fiscal policy and supply-side policies to try to keep the rate of inflation at 2%.

Question 25

Main issue with deflation

Answer 25

If consumers think that prices are falling then they might choose not to spend in the hope that prices will fall further.

Question 26

How are inflation and interest rates linked

Answer 26

1. inflation Expectations: When inflation is expected to rise, lenders and investors demand higher interest rates to compensate for the decrease in purchasing power of future returns. Conversely, when inflation is expected to fall, interest rates tend to decrease because lenders and investors are willing to accept lower returns. 2. Cost of Borrowing: Higher inflation typically leads to higher borrowing costs for businesses and consumers. Lenders charge higher interest rates to offset the erosion of purchasing power over time, leading to increased costs for borrowing money.

Question 27

cost of high inflation for the government

Answer 27

1. High inflation causes real GDP growth to slow down leading to lower tax revenues. 2. Pressure on the government to raise social welfare benefits. 3. Higher inflation can reduce government debt.

Question 28

Cost of high inflation on people

Answer 28

1. workers part of a trade union have a strong bargaining power so wages can rise with inflation. 2. Retired people on fixed income lose value of money. 3. Real purchasing power of income decreases rapidly.

Question 29

Economic costs of inflation

Answer 29

1. Inequality: Inflation has regressive effect on lower income families in developed and developing countries. 2. International competitiveness: A relatively high inflation can reduce international competitiveness of a country's exports.

Question 30

Impact of inflation on price mechanisms

Answer 30

Inflation distorts price mechanism and can result in inefficient allocation of resources.

Question 31

How does inflation cause a wage spiral effect.

Answer 31

A wage-price spiral is more likely when an increase in the actual cost of living leads to people raising their own expectations of inflation. Expectations of the future can drive behaviour today. The Central Bank is concerned to keep inflation expectations under control to help meet their inflation target.

Question 32

what classes as high inflation

Answer 32

inflation above 5%

Question 33

what classes as hyper inflation

Answer 33

inflation above 50%

Question 34

CPI limitations

Answer 34

- Time lag as CPI is slow ro respond to new products in market, and they only change once a year - Doesn't account for rise in the quality of a product which may cause price rises - CPI is national and may not capture regional variations in prices effectively. - There is no average