- What is inflation
- What is disinflation
- what is deflation
- The general increase in the general price level in an economy, which errodes the purchasing power of the currency
- Disinflation is a fall in the rate of inflation in an economy, but prices are still rising
- Deflation is the fall of the general price level in an economy, ie negative inflation
How does the CPI measure inflation?
A basket of 700 goods and services is created, which the ONS measures the price of every month.The goods ar weighted, so goods which take up a larger than average household spending are taken into account more. A % change of previous CPIs are calculated to give a rate of inflation. The basket of goods and the weightings are updated yearly to account for changes in consumer preferences.
What are the limitations of the CPI
- Does not take into account changes in quality - a product may get mire expensive due to an increase in quality, which is not inflation
- ‘Average family’ - individual households whose consumption patterns differ from the norm experice inflation in different ways, so is not totally accurate
- Does not take into account housing - housing tends to rise higher than most goods or services, so the CPI may be lower than it should be
What is the RPI?
It uses an arithmetic mean and includes mortages - this mean it often overestimates the true inflation rate experienced by households in the economy.
What are the two forms of inflation?
Demand pull
Cost push
What is demand pull inflation? How does it cause an increase in prices?
demand pull inflation occures when there is a shift to the right in AD. This occures due to the increasing demand put on exisitng factors of production, which increases their scrcity, thus increasing prices in the economy.
What is cost-push inflation? How does it cause an increase in prices?
cost push inflation occures when there is a shift to the left in sras.
This occures when there is a nationwide increase in the cost of production for firms, such as an oil price increase or an increase in the minimum wage. This means cost of production for firms increases, which they then pass on to consumers.
Which one is considered better?
Demand pull inflation is generall considered better - as the inflation at least comes with the benefits of economic growth.
What are the costs of inflation
- decreased purchasing power - inflation decreases the value of money, meaning income no longer goes as far (assuming that wages are not rising in line with inflation, which they usually do not in a market economy). This means that consumers are now worse off, and are less able to purchase necessities. This is particully bad for those on a fixed income such as pensioners who are unable to increase income
- inequality - As infation tends to be higher among necessities compared to luxouries, and lower socio-economic groups tend to spend a larger proportion of their income on necessities, the real cost of inflation will be higher for those in poverty.
- erosion of savings - the real value of interest rates will be negative, this discourages spending which will increase consumption and exacerbate the issue.
- Decreased international competitiveness - if the rate of inflation is higher in one country than an other , that countries exports will be less competitive, while imports will be more competitive. This has the effect of worsening the trade defecit.
- wage price spiral - The wage-price spiral is an economic phenomenon where inflation drives up the cost of goods and services, prompting workers to demand higher wages to maintain their purchasing power (especially if they are in a particularly strong trade union such as BMA) . As businesses face higher labor costs, they raise prices to compensate, further fueling inflation. This creates a self-reinforcing cycle
- menu - costs - firms have to spend resources changing the price of goods they are selling
- shoe leather costs - consumers spend time looking for the best deal, as they have asymetric information. This reduces productivity
- Fiscal drag - if incomes are increasing inline with inflation, this may drag some workers into higher tax brackets, meaning their real disposable income falls as they are taxed more even though real incomes have not risen
- inflationary noise - unanticipated inflation makes planning for the future impossibe, meaning firms may be less willing to invest as they are less certain of the future economic outlook, meaning that lras falls.
How does a growth in the monetary supply lead to inflation?
Persistent inflation can occure when the growth in the monetary supply exceeds growth in real national output. This leads to people having excess disposable income which they will naturallly spend, continously pushing ad to the right and increasing the national equilibrium price level.
What are the problems of deflation?
A liquidity trap is a situation described by Keynes where, despite low interest rates, monetary policy becomes ineffective at stimulating the economy. This happens when people and businesses prefer holding onto cash rather than spending or investing, often because they expect further economic decline or deflation. In such a scenario, even though central banks may lower interest rates to encourage borrowing and investment, the interest rate will always stay positive due to the falling prices - it is logical to postpone spending to wait for a better deal. As a result, monetary policy loses its potency, leading to stagnation or prolonged economic downturns. This is particularly problematic during periods of deflation, as people anticipate that prices will continue to fall, further reducing the incentive to spend or invest.
Why is low and stable inflation considered diserable (benefits of controlled inflation)
- gives room for error/adjustment before experiencing the problems associated with high infllation/deflation
- real value of debt falls overtime, allowing for consumers to be able to finance higher spending projects with more confidence.
- Dosnt impact saving as people suffer from money illlusion (thinking their money is staying the same value).
