2.4 Inflation

Question 1

What is inflation?

Answer 1

A sustained increase in the average price level of an economy over a given period of time

Question 2

What is deflation?

Answer 2

A sustained decrease in the average price level of an economy over a given period of time

Question 3

What is the inflation rate?

Answer 3

The percentage change in the average price level over a period of time

Question 4

What is disinflation?

Answer 4

A fall in the rate of inflation

Question 5

What is hyperinflation?

Answer 5

A very high rate of inflation; prices are increasing so fast that there is a severe loss of confidence in the value of money

Question 6

What do the CPI and CPIH use to measure inflation and how is it found?

Answer 6

The price of a representative basket of goods and services for a typical UK household. This is found by the Family Expenditure Survery (FES)

Question 7

What is the formula for the inflation rate calculated from the CPI?

Answer 7

(Index value in a given year - index value in previous year) / index value in previous year

X 100

Question 8

What are Owner Occupier Housing costs (OOH)?

Answer 8

The costs of housing services associated with owning, maintaining and living in one’s home.

Question 9

What is the method used to measure OOH costs in CPIH?

Answer 9

The rental equivalence method

Question 10

What is the rental equivalence method?

Answer 10

Measuring the price owner-occupiers would need to pay to rent their own home

Question 11

What are some difficulties in measuring inflation?

Answer 11

• The basket may not be fully representative for any specific household
• Time lags in inflation calculations as the basket is fixed each year which may not reflect consumer spending habits (eg. during covid in 2020 15% of items listed were not regularly purchased during 2020)
• Difficult to account for increasing quality (eg. smartphone)
• “Shrinkflation” - changing the size of products rather than the price could cause issues
• Sampling errors and errors in producing estimates can occur
• Consumers may switch to cheaper versions of some products, meaning cost of living will not increase as much as CPI
• CPI does not include OOH and households spend a large proportion of their money on housing

Question 12

What are the 3 causes of inflation?

Answer 12

Demand-pull inflation
Cost-push inflation
Monetary expansion

Question 13

What is demand-pull inflation?

Answer 13

When the price level is pulled up by increases in aggregate demand

Question 14

What is cost-push inflation?

Answer 14

When the price level is pushed up by a sustained increase in costs of production and a decrease in the SRAS

Question 15

What is monetary expansion?

Answer 15

More money chasing a fixed amount of goods and services will force up prices

Question 16

What are the costs of inflation?

Answer 16

• Economic costs - menu costs
  - shoe leather costs
  - administrative costs
• Reduction in the value of money - same amount of money buys less and cost of living increases
• Redistribution effects - some wages may not keep pace with inflation while others will
• Fall in real income and standard of living - if nominal wages do not rise by the inflation rate
• Redistribution from savers to borrowers - debtors gain as the value of debt falls and savers lose out as there is a fall in the real value of savings
• Inflationary ‘noise’ - rising prices can lead to market signals being distorted
• Fiscal drag - if tax brackets are not change in line with inflation there can be a redistribution from taxpayers to the government
• Inflation causing further inflation - inflation can lead to inflationary expectations which may cause AD and the price level to increase as economic agents bring forward their purchases, also due to increase wage demands
• Uncertainty - inflation can lead to uncertainty and loss of business and consumer confidence thus reducing economic activity
• Loss of international price-competitiveness - increase in trade deficit

Question 17

What are the possible benefits of low and stable inflation?

Answer 17

• Greater business and consumer confidence
• Low expectation of future inflation
• More flexibility for producers to decrease real wages by not increasing nominal pay at the rate of inflation as workers may be less demanding than if inflation was higher
• Avoiding deflation - the consequences of deflation may be more significant than any possible costs associated with low and stable inflation

Question 18

What do the effects of inflation depend on?

Answer 18

• The rate of inflation
• The inflation rate relative to other countries - if a country has a lower relative inflation rate it can still maintain its price competitiveness
• The duration - the longer inflation persists, the more harmful the consequences of inflation
• Causes of inflation - cost-push inflation is likely to be more harmful than demand-pull inflation as it is likely to be associated with a fall in output due to higher production costs
• Distribution of income - inflation may be harmful to some groups but beneficial to others (eg. debtors, creditors)

Question 19

What are possible causes of disinflation?

Answer 19

• A slowdown in the rate of increase of AD
• A slowing in the increase of costs of production
• LRAS increasing, slowing rate of increase in prices cause by rising AD
• Slower increases in the money supply: reduces rate of fall in the value of money thus rate of increase in prices and restricting the increase in money in circulation may cause those with money to hold on to it instead of spending

Question 20

What are the causes of deflation?

Answer 20

Benign deflation, malign deflation

Question 21

What is benign deflation?

Answer 21

When the price level is falling due to falling costs of production

Question 22

What is malign deflation?

Answer 22

When the price level is forced down by lower total spending on domestically produced goods and services

Question 23

What are the possible harmful effects of deflation?

Answer 23

• Increasing value of money - less incentive to spend
• Reduced consumer spending - consumers expect prices to fall further in the future so they delay purchases
• Reduced investment - as prices fall, more investment opportunities will be deemed unprofitable
• Increase real cost of borrowing - borrowers pay back more in real terms on their debts
• Lower profits for firms - may lead to higher unemployment
• Government fiscal harm - the real value of outstanding national debt will rise which will reduce the ability of the government to borrow in the future

Question 24

What are the possible benefits of deflation?

Answer 24

• Improves international price-competitiveness
• Possible increase in output - benign deflation could be beneficial

Question 25

What does the effect of deflation depend on?

Answer 25

- The rate of deflation - The duration - The cause of deflation - malign deflation more harmful - The international trade effect - dependent on PED for imports and exports - The level of indebtedness in the economy - the greater the level of existing debt, the more likely a decline in the level of economic activity

Question 26

What are nominal wages?

Answer 26

Money paid as the reward to labour per period of time at current prices

Question 27

What are real wages?

Answer 27

Money paid as the reward to labour per period of time, adjusted for inflation, to reflect the reward for labour in real terms

Question 28

What is a wage price spiral?

Answer 28

Rising inflation -> falling real incomes -> workers bid for improved wages -> leads to higher labour costs -> firms raise their prices -> rising inflation

Question 29

What are the causes of hyperinflation?

Answer 29

- Increasing inflationary expectations and ongoing monetary expansion leads to consumers bringing forward their purchases and firms raising prices further -> leads to wage price spirals

Question 30

What are the consequences of hyperinflation?

Answer 30

- Rapid fall in real incomes means consumers can no longer afford necessities -> deterioration of standards of living - Cash and financial assets held in domestic currency become worthless - ‘Capital flight’ -> assets, especially those with value in foreign economies, leave the economy - Inward FDI and investment in the domestic economy disappear - Alternative forms of exchange become common (eg. other currencies)

Question 31

What are the policies to reduce inflation?

Answer 31

Demand pull inflation: - Contractionary fiscal policy -> increased taxation, decreased government spending - Contractionary monetary policy -> increased bank rate Cost-push inflation: - Supply side policies to increase the efficiency of markets -> addresses inflation by increasing productivity Inflation targeting -> impacts inflationary expectations