Inflation

Question 1

Inflation

Answer 1

A sustained rise in general price level

Question 2

Deflation

Answer 2

A sustained fall in general price level

Question 3

Price Stability

Answer 3

A low and stable positive rate of inflation
1-3%

Question 4

Disinflation

Answer 4

A fall in the rate of inflation

Question 5

Current country examples - (China, Turkey, UK, US)

Answer 5

China - 0.1% due to falling fresh food prices
Turkey - 42.12% due to Turkish Lira crash in 2018
UK - 2.5% and has been falling steadily since 2022
US - 2.9% and has constantly decreased due to falling gas prices

Question 6

Consumer price index (CPI)

Answer 6

A measure of the average change over time in the prices paid by consumers for a representative basket of consumer goods and services
Measures the average household cost of living

Question 7

Benefits of CPI

Answer 7

Gives a realistic indication of consumer behaviour
Provides a better picture of spending patterns in the UK
More comparable measure of inflation internationally and represents internal best practice

Question 8

Limitations of CPI

Answer 8

Changes in quality of goods being priced
Special offers not considered
Changes in expenditure
Composition of the basket of goods - this changes so isn’t like for like
Average household doesn’t exist
Not all regions within a country experience identical price changes
Potential for sampling error

Question 9

Retail price index (RPI)

Answer 9

The ‘headline rate of inflation’

Question 10

RPI-X

Answer 10

Underlying rate of inflation
RPI inflation but excludes mortgage interest payments
Allows policy makers to view inflation rates without distortion of changes in house prices

Question 11

RPI-Y

Answer 11

Inflation excluding mortgage interest payments and indirect taxes
VAT rates rarely change, but taxes on alcohol, tobacco and fuels may distort index figures

Question 12

How CPI and RPI are measured

Answer 12

Weights - goods/services included are chosen and weighted on basis of spending patterns of UK households from the family expenditure survey
Prices - index measures price movement of 700 goods and services in 150 areas with a monthly price survey calculating 180,000 prices
Prices are multiplied by their weights to calculate RPI
Indexed - all index numbers refer to base number of 100

Question 13

Differences between CPI and RPI

Answer 13

CPI excludes some items included in RPI-X (such as council tax, mortgage interest payments, buildings insurance)
CPI includes charges for financial services which the RPI doesn’t
CPI covers all private households, whereas RPI-X excludes the top 4% by income and pensioner households who derive 75%+ of income from state benefits
CPI includes residents of institutional households like student hostels, and foreign visitors to the UK

Question 14

Producer price index (PPI)

Answer 14

PPI measures change in prices of goods bought / sold by UK manufacturers
Output price indices measure change in prices of goods produced by UK manufacturers
Input price indices measure change in prices of materials/fuels bought by UK manufacturers for processing and day-to-day operations

Question 15

Demand pull inflation

Answer 15

Occurs when demand for goods and services exceeds the available supply of those goods and services in the economy
Output rises, PL rises, unemployment falls

Question 16

Demand pull inflation chains of reasoning

Answer 16

Depreciation of exchange rate → WPIDEC → exports increase, imports decrease → AD increases so PL increases → cost push inflation due to expensive imports
Fall in interest rates → cost of borrowing decreases and less saving → C and I increase → hot money inflows decrease → AD increases so PL increases
Faster economic growth in other countries → more income per hour in other countries → increases demand for UK exports → X-M increases so AD increases so PL increases
Reduction in direct tax → lower income tax so more disposable income so increased C → lower corporation tax so more profit so increased I → Increases AD so PL increases

Question 17

Cost push inflation

Answer 17

Occurs as a result of an increase in the unit costs of production, so prices tend to rise to protect profit margins
Output falls, PL increases, unemployment increases

Question 18

Cost push inflation chains of reasoning

Answer 18

High global prices for components and raw materials → higher cost of production→ SRAS shifts left
Rising unit labour costs → higher cost of production →SRAS shifts left
Higher indirect taxes → higher cost of production → taxes borne by producer so SRAS shifts left and AD contracts

Question 19

Inflation targeting

Answer 19

Public numerical target for inflation set by a central bank
e.g. BoE is 2%

Question 20

Advantages of inflation targeting

Answer 20

Lower rate of inflation - in countries with high inflation it is a method to reduce it
More stable rate of inflation - reduced fluctuation when target is pursued and leads to more stable IR (confidence)
Anchors inflationary expectations → improved ability of economic decision makers to anticipate future rate of inflation - reduces uncertainty as public know the aim of central bank
Benefits of low inflation e.g increased international competetiveness

Question 21

Disadvantages of inflation targeting

Answer 21

Reduced ability to pursue other objectives
Supply shocks will change inflation but demand-side monetary policy may be ineffective at dealing with this and lead to undesirable trade-offs with growth and unemployment
Reduced ability to respons to financial crises - may require expansionary MP which would lead to higher than target inflation
Short-run Phillips curve suggests trade-off with higher unemployment
Lowers consumption / fall in confidence → less profits + investment
High G to stimulate economy creates huge budget deficit

Question 22

Cost of inflation to consumers

Answer 22

Decrease in purchasing power therefore less disposable income so lower living standards and cost of living crisis
‘Shoe leather costs’ - increased time spent by consumers working out what the correct price is for goods and services following a period of high inflation

Question 23

Cost of inflation to businesses

Answer 23

Cost of production increases as workers demand higher wages so less demand for goods
Profits go down so firms invest less
Menu costs - firms waste time and money reprinting menus with new prices

Question 24

Cost of inflation to workers

Answer 24

PL increases due to inflation, meaning workers demand higher wages → real income goes down so can lead to wage price spiral (worse for low-paid workers with less bargaining power so inequality increases)
Unemployment increases as cost of production for the firm increases (due to high wages demanded) so they can’t pay for the same amount of workers

Question 25

Cost of inflation to the economy

Answer 25

Lower C and I so lower AD so negative multiplier Higher interest rates to combat inflation further, increasing MPS and less growth Lower RY as SRAS shifts out if it is cost push inflation Unemployment increases Less international competetiveness so less X and more M so trade balance worsens