Inflation

Question 1

Define the following terms
Inflation
Disinflation
Deflation

Answer 1

Inflation- sustained increase in the general price level
Disinflation- reduction in the rate of inflation
Deflation- sustained decrease in the general price level

Question 2

How is CPI (Consumer Price Index) calculated to get the price level?

Answer 2

1. Office of National Statistics conducts the Living Costs and Food Survey, surveys 7000 households to find the 650 most commonly bought goods and services
2. The proportion of income spent on each good/service is calculated and a weighted average is assigned to each
3. Multiplying the weighted average by the average price of the good, and add them all up to get the price level for that year

Question 3

Limitations of CPI

Answer 3

-not totally representative of all goods/services
-not fully representative of all households
-difficult to make comparisons with historical data
-time lag
- cost and time ineffective

Question 4

Name and explain the 2 causes of inflation
(there’s also a 3rd, but uncommonly mentioned one)

Answer 4

Demand-pull: caused by an increase in AD

Cost Push: caused by a decrease in AS as a result of increased production costs.

Growth of Money supply: if people have more access to money but the number of goods/services doesn’t increase by as much, prices will rise

Question 5

Effects of inflation on consumers

Answer 5

-reduced purchasing power
-value of savings decrease
-uncertainty, harder to plan savings
- Borrowers benefit as the real value of debt falls

Question 6

Effects of inflation on producers

Answer 6

-higher costs due to increased input prices
-reduced price competitiveness in international markets
-Uncertainty: Firms may delay investment due to unpredictable future costs.

Question 7

Effects of inflation on government

Answer 7

-Increased Tax Revenue: Rising prices lead to higher VAT and income tax revenue if incomes rise.
-Debt Erosion: The real value of government debt decreases, benefiting borrowers.

Question 8

Effects of inflation on workers

Answer 8

-Falling Real Wages: If wage increases don’t match inflation, workers’ purchasing power declines.
-Job Insecurity: Firms facing higher costs may cut jobs or reduce hiring.

Question 9

How do we calculate the inflation rate after the CPI process

Answer 9

1.Set base year to a CPI of 100

2. (index from current year-index from base year)/index from base year
3. Multiply that number by 100 to get the inflation rate

Question 10

Describe the deflationary spiral

Answer 10

When there is deflation,consumers would delay purchases waiting for prices to decrease further
This meant that consumers saved more and spent less,decreasing consumption,shifting in AD and decreasing the general price level

A decrease in consumption meant that firms had to lay off more workers,increasing unemployment and decreasing real GDP,decreasing actual economic growth

This would continue more and more

Question 11

Effect of inflation on exports, AD and Terms of Trade

Answer 11

-Higher export prices means an improvement in the terms of trade
-Higher export prices, reduction in exports, reduction in AD