CH34 Inflation

Question 1

what is inflation?

Answer 1

it is a general sustained rise in the price level

Question 2

how is inflation measured?

Answer 2

it is measured by calculating the change in a weighted price index over time.

Question 3

What is the opposite of inflation?

Answer 3

the opposite of inflation is: deflation
-this is defined as a sustained general fall in the price level.

Question 4

what is disinflation?

Answer 4

it is the fall in the rate of inflation

Question 5

if there is disinflation, does it still mean that there is inflation?

Answer 5

yes. Even if there is disinflation there is still inflation, but the rate of inflation (the rate at which prices are rising) is falling

Question 6

what situation does creeping inflation describe?

Answer 6

creeping inflation describes a situation where prices rose a few percent on average each year.

Question 7

what situation does hyperinflation describe?

Answer 7

hyperinflation describes a situation where inflation levels are very high.

Question 8

is there an exact figure when inflation becomes hyperinflation?

Answer 8

no. However, annual inflation rated of 50percent or more would be classified as hyperinflation by most economists.

Question 9

hat does the term reflation describe?

Answer 9

it is used to describe the rise in GDP which occurs following a recession.

Question 10

what is the term stagflation used to describe?

Answer 10

it is used to describe a period when inflation is rising or is very high at a time when the economy is in recession

Question 11

what are deflationary policies?

Answer 11

these are policies pursued by govs, which are designed to reduce the rate of economic growth. If successful, they will almost certainly also reduce the rate of growth of inflation.

Question 12

what is the inflation rate?

Answer 12

it is the change in average prices in an economy over a given period of time.

Question 13

in what form is the price level measured in?

Answer 13

in the form of an index

Question 14

what are the two widely used measures of the price level in the UK?

Answer 14

-the consumer prices index
-the retail prices index

Question 15

what are the 2 main factors which can cause inflation?

Answer 15

demand-pull and cost-push inflation

Question 16

what is demand-pull inflation?

Answer 16

it is when aggregate or total demand rises and there is no increase in aggregate supply.
-i.e. it is caused by excess demand in the economy

Question 17

what are 4 reasons why excessive increases in aggregate demand in the UK can come about?

Answer 17

-consumers spending may rise excessively. Interest rates could be low and consumers are spending large amounts on their credit cards, or consumer confidence could be rising because house prices are rising
-firms may substantially increase their spending on investment. Perhaps they are responding to large increases in demand from consumers and need extra capacity to satisfy that demand.
-the gov might be increasing its spending substantially, or it could be cutting taxes.
-world demand for UK exports may be rising because of a boom in the world economy.

Question 18

can demand-pull inflation also be caused by growth of the money supply? explain how

Answer 18

yes it can be caused by growth in the money supply
-Both central banks, and the banking system can influence the amount of borrowing and lending in the economy. If banks increase their lending to customers, the money supply will grow.
-customers are likely to spend the money they have borrowed. The result will be increased aggregate demand. This can cause inflation.

Question 19

when does cost-push inflation occur?

Answer 19

cost-push inflation occurs when costs increase, so producers pass on these costs to consumers by raising the prices.

Question 20

what are the 4 major sources of increased costs?

Answer 20

-wages and salaries account for about 50% of national income and hence increases in wages are normally the single most important cause of increases in costs of production.
-imports can cause a rise in price. A boom in the world economy, for example, may push up commodity prices such as oil, copper and wheat. It will also push up the price of finished goods. This will lead to higher import prices for the UK.
-profits can be increased by firms when they raise prices to improve profit margins. The more price inelastic the demand for their goods, the less will such behaviour result in a fall in demand for their products.
-governments can raise indirect tax rates or reduce subsidies, thus increasing prices

Question 21

what are the economic costs of inflation?

Answer 21

-growth and unemployment: unpredictable inflation can result in lower consumption by consumers, which leads to lower levels of output and higher levels of unemployment.
-competitiveness: if inflation in the UK is higher compared to other countries, then exports will become more expensive, and imports will be more competitive. This can result in a loss of jobs in the UK and lower growth.
-redistributional costs: inflation can redistribute income and wealth between households, firms and the state. This can occur in a variety of ways. For instance, anybody on a fixed income will suffer.
-psychological and political costs: people feel that they are worse off, even if their incomes rise by more than the rate of inflation.
-shoe-leather costs: at times of rising prices, consumers and firms will be less clear about what is a reasonable price. This will lead to more ‘shopping around’, which in itself is a cost. Higher rates of inflation are also likely to lead to households and firms holding less cash and more interest-bearing deposits.
-menu costs: when there is inflation, restaurants have to change their menus to show increased prices. Similarly, shops have to change their price labels and firms have to calculate and issue new price lists.

Question 22

what does anticipated inflation allow?

Answer 22

it allows economic actors to plan for the future and adjust their decision to take inflation into account.
-one way of doing this is through indexation. This is where economic variables like wages or taxes are increased in line with inflation.

Question 23

why are economists divided about whether indexation provides a solution to the problem of inflation?

Answer 23

-on the one hand, it reduces many of the costs of inflation although some costs such as shoe leather costs and menu costs remain.
-on the other hand, it reduces pressure on government to tackle the problem of inflation directly. Indexation eases the pain of inflation but is not a cure for it.
-moreover, indexation may hinder government attempts to reduce inflation because indexation builds in further cost increases, such as wage increases, which reflect past changes in prices.

Question 24

what are the costs of deflation?

Answer 24

-between 1995 and 2014, Japan had experienced years of falling prices and had serious impacts on the economy.
-with falling prices, consumer confidence tends to be low. Consumers are concerned about the future and know that if they dont buy today, they might be able to buy at a cheaper price tomorrow. A lack of consumer confidence then feeds into a lack of business confidence and lower investment.
-although interest rates tend to be very low with deflation, the real cost of borrowing is higher. If prices fall by, say, 1%, then the real cost of borrowing is higher. If prices fall by, say, 1%, then the real cost of borrowing is the actual or nominal interest rate plus one percent.
-the other major problem with deflation is the effect on asset values. Savers can see the real value of their savings grown even if they only receive one or two percent interest. If prices fall by 2% and they receive 1% interst, then the real rate of return on their savings is 3%.
-deflation encourages households to save rather than spend and this leads to low or negative rates of economic growth.
-for borrowers, deflation leads to the real value of their debt increasing. This will discourage households and firms from borrowing and spending and so reduces AD

Question 25

what are the benefits of low inflation?

Answer 25

-an inflation rate of 2% avoids the problems associated with high inflation or deflation. It gives policy makers, such as central banks, room to adjust the economy if inflation goes higher or lower.
-another reason by 2% is considered desirable is because of its effect on assets prices. At 2%, the real value of borrowing falls gradually over time. This is seen as desirable because it makes it easier for those who borrow to finance consumption or investment to repay their borrowings. It also doesn’t impact much on the incentive to save because it is argued that savers dont take the real erosion of their savings into account, They suffer from money illusion, thinking that inflation is zero.