2.1.2 - Inflation

Question 1

What is inflation

Answer 1

• A sustained increase in the general price level
• leads to a fall in the real purchasing power of money

Question 2

How is the rate of inflation measured

Answer 2

Annual percentage change in consumer prices

Question 3

What is deflation

Answer 3

A fall in the general price level ‘negative inflation’

Question 4

What is disinflation

Answer 4

• A slowdown in the rate of increases in prices
• Prices are still rising but at a slower rate

Question 5

What is the consumer price index (CPI)

Answer 5

A measure of the price level based on the prices of a collection of products designed to reflect the consumption basket of the average consumer

Question 6

How does the CPI work

Answer 6

• A base year for prices is selected and a family expenditure survey is carried out, the survey tracks what people are buying
• A representative basket of over 600 goods and services used, weights attached to each item based on items importance in people’s expenditure
• Weights are multiplied by price changes
• Weighted price changes are totalled to calculate inflation rate

Question 7

How do you calculate CPI

Answer 7

Sum of price indices x weights / sum of weights

Question 8

Limitations of CPI as a measure of inflation

Answer 8

• CPI is not fully representative, inaccurate for the ‘non-typical’ household
• Spending patterns
• Changing quality of goods and services, although price could rise, may be accompanied by improvements in quality/performance
• Doesn’t account for regional differences in cost of living

Question 9

What is hyper-inflation

Answer 9

• A period of high rates in inflation, usually leading to a loss of confidence in an economy’s currency

Question 10

Name some domestic causes of inflation

Answer 10

• Rising wage costs
• Increases in the costs of component parts of raw materials

Question 11

List some external causes of inflation

Answer 11

• Increase in the global price/cost of energy and other inputs
• Movements in the exchange rate of a country’s currency, e.g. currency weakens, imported goods will become more expensive pushing up domestic production costs

Question 12

What is the importance of inflation expectations

Answer 12

• Agents (e.g. workers, businesses and lenders) will raise their inflation expectations and build it into their calculations and decision
• Rise in inflation can lead to an increase in inflation expectations, can feed through to higher wage claims and rising costs

Question 13

When does cost push inflation occur

Answer 13

• When the costs of production for businesses increase
• E.g. increases in wage costs, cost of raw materials, rents or indirect taxes such as VAT

Question 14

What happens during cost-push inflation

Answer 14

• Output of goods/services and employment both fall due to a rise in costs leading to a fall in business profits and planned investment spending
• Cost-push inflation can bring about stagflation, slow growth and inflation

Question 15

When does demand pull inflation occur

Answer 15

• When total demand for goods/services exceeds total supply
• As economy approaches full employment, labour and raw material shortages occur more frequently making it more difficult for firms to expand production to meet rising demand

Question 16

What happens during demand pull inflation

Answer 16

When total demand in economy rises, producers encouraged to raise prices and increase profit margins, causing general price level to rise

Question 17

Winners from rising inflation

Answer 17

• Workers with strong wage bargaining power
• Producers if their prices rise faster than costs
• Wealthy groups if there is a period of asset price inflation

Question 18

Losers from rising inflation

Answer 18

• Retired people on fixed incomes
• Workers in low paid jobs with little or no bargaining power
• Exporting firms may lose sales and profits if they become less competitive, hitting shareholders

Question 19

List some of the risks of high and volatile inflation

Answer 19

• Falling real incomes, if wage rises lag behind price increases
• Negative real interest rates, interest on savings is lower than inflation, cuts real incomes of savers
• Business competitiveness, reduce competitiveness, reduced demand for country’s exports in overseas markets

Question 20

Causes of deflation: demand-sides causes

Answer 20

• Deep fall in total demand in an economy, causing a persistent recession/depression
• Usually characterised by a high level of spare capacity

Question 21

Causes of deflation: supply-side causes

Answer 21

• Total supply in an economy rises more quickly than total demand
• Improved productivity of labour and capital
• Technological advances in production process that lowers unit costs
• Falling wage rates
• High exchange rate causing import prices to fall

Question 22

Economic effects of deflation

Answer 22

• Debts increase: real value of debt rises, drag on consumer confidence and spending
• Real cost of borrowing increases: real interest rates will rise if nominal interest rates don’t fall in line with prices
• Confidence and saving: falling asset prices hits personal sector wealth and confidence