2.2 Inflation Flashcards
How is inflation measured using the Consumer Price Index (CPI)?
The CPI measure of inflation starts by forming a basket of goods and services that reflects the consumer habits of the average family in a nation using survey data. These goods and services are then weighted according to the quantity bought by multiplying the average price of the good or service by the weight to provide a weighted value of the basket. A base year is selected, where the raw value of the basket in that year is given the index value of 100. Annual changes in the raw value of this basket are indexed and compared to the base year with a simple percentage change calculation between annual index figures generating the inflation rate year on year. Each year, the basket of goods and services is updated to reflect changes in consumer habits and weights are changed to reflect changes in the proportion of income spent on basket goods and services.
What are the problems with using the CPI to measure inflation?
The basket of goods and services generated may not reflect the consumption habits of all consumers in the economy, meaning the inflation rate rise may not be representative of all consumers. Additionally, there will always be issues with how quickly the basket of goods and services is changed according to changes in the consumption habits of a nation. For the CPI to represent inflation for all households, the basket must be as up to date as possible and therefore changed regularly. If this is not done regularly due to financial pressures or done incorrectly, the inflation figures generated may not be reflective of current c
Why is the CPI basket prone to seasonal fluctuations, and how does this impact the measurement of inflation?
The CPI basket is prone to seasonal fluctuations, particularly for goods and services that are weighted heavily and contribute to inflation, such as gas, petrol, and food. Seasonal factors, such as a very cold winter or excessive summer rains, can drastically impact the prices of these goods and services and artificially push up inflation. This can lead to a fluctuating CPI inflation rate without providing a sense of the underlying trend in prices throughout the rest of the economy. For this reason, core inflation, which excludes food, gas, and petrol prices, is often used alongside the CPI inflation rate to gain perspective of the ‘underlying rate of inflation.’ In January 2015, the UK experienced large disinflation due to falling gas and petrol prices, with CPI inflation at 0.5%. Yet the core rate of inflation stood at a healthy 1.6%, indicating that prices generally in the economy were rising close to the target rate.
What happens to the cost of borrowing when interest rates are cut?
A cut in interest rates reduces the cost of borrowing, making it cheaper for consumers to borrow, which in turn reduces the opportunity cost of doing so.
How does a cut in interest rates affect savings?
A cut in interest rates reduces the rate of return on savings, which decreases the incentive to save and increases the incentive to spend or borrow. As a result, the savings ratio in the economy will decrease with more consumer spending taking place.
How does a cut in interest rates affect monthly payments for homeowners with tracker or variable rate mortgages?
A cut in interest rates will reduce the monthly payments for homeowners with tracker or variable rate mortgages. This increase in disposable income for these homeowners will increase their marginal propensity to consume, thus boosting consumption in the economy.
How does a cut in interest rates affect borrowing costs for firms?
A cut in interest rates will reduce the cost of borrowing for firms, making it easier for them to reach their hurdle rate (the required rate of return for investment projects to go ahead). This increases the marginal propensity for firms to invest, increasing I in the AD equation and shifting AD to the right from AD1 to AD2.
How can governments increase consumption in the economy for those on lower incomes?
Governments can reduce the marginal rate of income tax for those in lower income tax bands or increase the income tax free allowance, which would increase disposable income for those on lower incomes. As these consumers have a higher marginal propensity to consume, consumption would increase in the economy, increasing AD from AD1 to AD2.
How can reducing the level of corporation tax affect investment and AD?
Governments can reduce the level of corporation tax, which will increase retained profits for businesses, making it easier for them to finance investment and increasing the marginal propensity to invest. As investment increases, AD will also increase from AD1 to AD2, as I is a component of AD.
How can government spending on infrastructure, education, healthcare, public sector wages, etc., affect AD?
Governments can boost their spending in the economy, for example, by spending on infrastructure, education, healthcare, public sector wages, etc. As G is a core component of AD, this will significantly increase AD from AD1 to AD2 and generate a large multiplier effect in the economy, whereby an initial increase in spending (AD) will increase incomes in the economy, facilitating further rounds of spending and income generation. The end result is an even greater final increase in AD.
How can weakening the exchange rate affect AD?
Weakening the exchange rate, for example, by reducing interest rates (increase hot money outflows), increasing the money supply or selling domestic currency reserves, makes exports cheaper and imports dearer. The demand for imports and, therefore, the expenditure on imports will decrease, while the demand for exports and, therefore, the revenue generated by exports will increase. Both effects will lead to an improvement in the trade balance of the current account and reduce a current account deficit or move it to surplus. As (X-M) is a component of aggregate demand, AD will rise from AD1 to AD2.
How does demand-pull inflation arise?
Demand-pull inflation arises due to more pressure and competition for existing factors of production, increasing their price, which will feed through to higher prices of goods and services in the economy. As a result, demand pull inflation increases from P1 to P2.
How can an increase in wages affect SRAS?
An increase in wages, e.g., due to higher minimum wages, growing trade union strength, anticipated inflation, and low unemployment, will increase costs of production and shift SRAS to the left from SRAS1 to SRAS2. Firms will pass on these higher costs via higher prices, hence increasing cost push inflation.
How can a weak exchange rate affect SRAS?
A weak exchange rate will make imports dearer when bought in foreign currency, thus for firms that import raw materials, costs of production will rise, shifting SRAS to the left from SRAS1 to SRAS2. Firms will pass on these higher costs via higher prices, hence increasing cost push inflation.
How does inflation affect purchasing power?
Inflation causes a decrease in purchasing power as those on fixed incomes suffer a decrease in their real income. As a consequence, spending power reduces, decreasing consumption in the economy and the overall level of aggregate demand.
