inflation

Question 1

Inflation and it’s measurements

Answer 1

• Inflation means a sustained increase in the general price level. Inflation means the value of money will decrease.
• CPI – official measure of inflation. Excludes mortgage interest payments.
• RPI (Retail Price Index) – includes mortgage interest payments. Used to be the official measure.
• Inflation of 2010/11 was caused by cost-push factors, such as higher taxes, effect of devaluation, and rising commodity prices.

Question 2

Costs of Inflation 1

Answer 2

• Cost of reducing inflation: High inflation is deemed unacceptable therefore governments feel it is best to reduce it. This will involve higher interest rates; the reduction in AD will lead to a decline in economic growth and unemployment.
• International competitiveness: Higher UK inflation will make British goods less competitive, leading to a fall in exports. However, this may be offset by a decline in the exchange rate
• Confusion and Uncertainty: When inflation is high people are uncertain what to spend their money on. Also, firms may be less willing to invest because they are uncertain about future profits and costs. This can lead to lower growth in the long term.

Question 3

Costs of Inflation 2

Answer 3

• Menu Costs: This is the cost of changing price lists frequently.
• Shoe leather costs: To save on losing interest in a bank people will hold less cash and make more trips to the bank
• Income redistribution: Borrowers will become better off; lenders will become worse off. However it depends on the real rate of interest.
• Boom and bust economic cycles: High inflationary growth is unsustainable and is usually followed by a recession.

Question 4

Money supply

Answer 4

This measures the amount of money in the economy
•M0 = the level of notes and coins in circulation + banks operational balances at the Bank of England (this is known as narrow money)
•M4 = notes and coins in circulation plus private sector deposits in banks and building societies

Question 5

Causes of Inflation - Monetarist Theory

Answer 5

Monetarists argue that if the Money Supply rises faster than the rate of growth of national income then there will be inflation.

Question 6

Causes of Inflation - Monetarist Theory - Quantity theory of money (Fisher equation)

Answer 6

MV=PY (M = Money Supply, V = Velocity of circulation, P = Price Level, Y = National Income).
• Monetarists believe that in the short term velocity (V) is fixed
• Monetarists also believe Output (Y) is fixed by supply side factors. If there is a change in the money supply then Y will quickly return to its long run (natural) equilibrium. Note LRAS is inelastic in Monetarist model.
Therefore an increase in the Money Supply (M) faster than the growth of national income will lead to an increase in (P) inflation.

Question 7

Monetarist inflation in the AD and AS model

Answer 7

i) Following a rise in the MS consumers have more money so spend more on goods, this shifts AD to the right.
ii) Firms respond by increasing output along SRAS, but this causes inflation to increase.
iii) Also firms need to hire more workers, so wages rise leading to an increase in costs and hence prices. Therefore, SRAS shifts to the left.
iv) As prices rise money can buy less therefore there is a movement to the left along the new AD until price level equals P2.
v) The economy has returned to the equilibrium level of output Yf, but at a higher price level P2.

Question 8

Criticisms of Monetarism

Answer 8

1. Evidence in the 1980s showed that the money supply could grow much faster than the price level suggesting the link was not true.
2. The Velocity of Circulation (V) is not stable, but can change due to factors such as increase in the use of credit cards. Growth in the money supply can be erratic and due to institutional factors e.g. more cash machines caused an increase in M0
3. Monetarists say that income can vary in the short run, but the short run could be a long time and therefore make monetary policy ineffective. Keynesians argue that the LRAS is not necessarily inelastic; they argue that the economy can be below full capacity for a long time.

Question 9

Causes of inflation - Keynesian View (demand pull inflation)

Answer 9

• If the economy is at or close to full employment then an increase in AD leads to an increase in the price level.
• An increase in AD will not always cause inflation if there is spare capacity in the economy.

Question 10

demand pull inflation causes

Answer 10

Demand Pull inflation can be caused by many factors such as

1. Loose Monetary policy - If interest rates are too low then AD will increase faster than AS and the rate of economic growth will be unsustainable.
2. High consumer confidence and spending - If wages are increasing and consumers are optimistic about the future they will increase there spending causing AD to increase.

Question 11

Causes of inflation - Cost push inflation

Answer 11

If there is an increase in the costs of firms then firms will pass this on to consumers. There will be a shift to the left in the SRAS. Cost-push inflation can be caused by factors such as:

1. Wage Push Inflation - Trades unions can bargain for higher wages, this will lead to an increase in costs for firms. It may also cause demand-pull inflation as consumers spend more.
2. Import prices - One third of all goods are imported in the UK. If there is a devaluation then import prices will become more expensive leading to an increase in inflation.
3. Raw Material Prices - If the oil price increases by 20% then this will have a significant impact on firms’ costs and therefore inflation.

Question 12

Evaluation of Inflation targeting 1

Answer 12

• The Monetary Policy Committee (MPC) was made independent in 1997. This means the MPC is responsible for setting interest rates and attaining the government’s inflation target of 2%.
• Between 1997 and 2007, inflation remained low and economic growth positive. This was considered to be a great success.
• However, during the great moderation (97-2007) there was a boom in bank lending and house prices. In 2007, the credit crunch led to a serious recession. This shows the limitation of targeting inflation. Other problems were ignored.

Question 13

Evaluation of Inflation targeting 2

Answer 13

• During the recession of 2009-13, inflation has often been above target. This is due to cost-push factors, such as devaluation, rising oil prices and higher taxes. However, the MPC couldn’t have reduced inflation without causing a deeper recession, and has been more successful in keeping inflation low.
• The MPC introduced quantitative easing to boost money supply, but this had little effect in ending the recession.

Question 14

Falling inflation

Answer 14

does not mean falling prices

Question 15

Calculating a weighted price index

Answer 15

CPI is a weighted price index. Changes in weights reflect shifts in the spending patterns of households in the British economy as measured by the Family Expenditure Survey.
Weights are attached to each category; we multiply these weights to the price index for each item of spending for a given year.
The price index for this year is: the sum of (price x weight) / sum of the weights