4.6 Price stability

Question 1

What is inflation?

Answer 1

Inflation is the sustained increase in the overall price level in an economy in a year

Question 2

What is disinflation?

Answer 2

Disinflation is a fall in the rate of inflation
Just a drop e.g. 6% to 3%

Question 3

What is deflation?

Answer 3

A negative inflation rate
E.g, -3%

Question 4

How can inflation rate be calculated?

Answer 4

(Change in CPI / previous year cpi) x 100
Basically just a percentage change in CPI

Question 5

What is CPI?

Answer 5

-It is the price of a weighted average basket of consumer goods and services purchased by households
-Changes in CPI track changes in price over time

Question 6

What are some limitations of CPI?

Answer 6

The CPI is not fully representative
People’s spending patterns are different
New products aren’t included in the CPI
It doesn’t account for the regional differences in the cost of living
Changing quality of goods and services

Question 7

What is the money value of data?

Answer 7

It is the nominal value, it is not adjusted for inflation

Question 8

What are the causes of inflation?

Answer 8

There is demand-pull inflation
There is cost-push inflation
Growth of the money supply

Question 9

What is demand-pull inflation?

Answer 9

This is when AD is growing unsustainably so there is pressure on resources. Producers increase their prices and earn even more profit. It usually occurs when resources are fully employed

Question 10

What are the main triggers for demand pull inflation?

Answer 10

A depreciation in the exchange rate, causes imports to be more expensive while exports become cheaper. This causes AD to rise

Fiscal stimulus in the form of lower taxes or more gov spending. This means consumers have more disposable income, so spending increases.

Lower interest rates makes saving less attractive and borrowing more attractive so spending and investment increases

High growth in UK export markets means UK exports increase and AD increases

High consumer and business confidence

Question 11

What is cost push inflation?

Answer 11

This is from the supply side of the economy and occurs when firms face rising costs.

Question 12

What are the main triggers for cost push inflation?

Answer 12

Raw materials become more expensive
Labour becomes more expensive
expectations of inflation - if consumers expect prices to rise they might ask for higher wages to make up for this which could trigger more inflation
Indirect taxes could increase the cost of goods such as cigs or petrol if producers decide to pass this cost onto consumers. Also business taxes like VAT will rise.
Depreciation in the exchange rate makes imports more expensive which could cause the price of raw materials to rise

Question 13

What is growth of the money supply?

Answer 13

If the BofE printed more money, there would be more money flowing into the economy. Extreme increases in the money supply usually causes hyperinflation, when the rate of inflation is incredibly high and uncontrollable.

Question 14

What is quantitative easing?

Answer 14

When interest is already very low, it is not possible to lower them much more. This means that the bank had to adopt another measure which pumps money directly into the economy. So the bank buys assets in the form of gov bonds using the money they have created. This is then used to buy bonds from investors, which increases the amount of cash flowing into the financial system. This encourages more lending to firms and individuals which increases spending and investment which leads to higher growth

Question 15

What are the effects of inflation on consumers?

Answer 15

Those on low and fixed incomes are hit hardest by inflation due to its regressive effect as the cost of basic necessities increases. The purchasing power of money falls which affects those with high incomes the least.
If consumers have loans, the value of the repayment will be lower because the amount owed doesn’t increase with inflation, so the real value of debt decreases

Question 16

What are the effects of inflation on firms

Answer 16

Low interest means borrowing and investment is more attractive than saving. With high inflation rates, interest rates are likely to be higher so the cost of investing will be higher so firms are less likely to invest
Workers might demand higher wages, which could increase the costs of production for firms
Firms may be less price competitive on a global scale if the price is high
Unpredictable inflation will reduce business confidence since they are not aware of what their costs will be

Question 17

What are the effects of inflation on the government?

Answer 17

The gov will have to increase the value of the state pension and welfare payments as the cost oof living is increasing

Question 18

What are the effects of inflation on workers?

Answer 18

Real incomes fall with inflation so workers have less disposable income
If firms face higher costs, there could be more redundancies when firms try to cut their costs

Question 19

Costs benefits and evaluation of inflation

Answer 19

Costs of high inflation:
Loss of purchasing powers for workers in the economy. Assuming incomes don’t rise in line with inflation, in real terms they are worse off which affects their living standards. Drive them into poverty and deprivation
Erodes savings. Interest rates aren’t rising in line with inflation which means they are losing value. Effects those who are relying on their savings. Elderly and economically inactive. There will be shoe leather costs which is where people will waste a lot of time searching for different banks that give the highest rate of interest. Lot of time and effort which comes with an opportunity cost
Erodes export competitiveness internationally if inflation in ur country is comparitively high. This will worsen CA deficit. Especially harmful for trade dominant country
Anticipated inflation could spiral and lead to hyperinflation. Workers will bargain for higher wages which is at least equal to inflation which will increase the costs of production and they will pass that on by higher prices and then this happens again and again. Maybe also when consumers expecting higher inflation, you bring forward your consumption as you can buy them now when they are cheaper
Also could have menu costs
Fiscal drag is when inflation is rising and workers are receiving higher income but only in line with higher inflation. In real terms they are not better off. But if that pay rise means they get dragged into higher tax bands then they are worse off. Their living standards will decrease. Govs like it as they gain tax revenue. Assumption here is tax bands don’t rise in line with inflation
Inflationary noise - when the rate is volatile which means price signalling function loses its value. When prices go up it is because of a shortage in a market and the opposite for low prices. But when inflation is volatile, people start to lose the understanding of whats happening with price and why. This gives uncertainty which is not good for consumption and investment

Benefits of stable inflation:
Workers can bargain for higher wages even if it is just inflation equalling. The point is they like higher income which is good for morale and productivity. Also with low and sable inflation, consumption will happen naturally.
Firms encouraged to increase output as they know they can increase prices and earn more revenue
Unemployment stays low in a recession. Firms can raise prices by 5% and increase revenue and if they give workers 1% pay rise then they can still remain relatively profitable and now they keep their productive workforce and are keeping a lid on their costs.
It also reduces the real value of debt. Becomes easier to service debt as you have more money to your name through pay rises profits revenues etc
Can improve state of gov finances. As prices rise, gov collects more revenue on different types of taxes. Also govs might not be spending as much on public services etc

Evaluation:
The rate is key. Low and stable means more benefits than costs but other way around it is dangerous and u risk spirals
Demand pull is more favourable than cost push. This is as you get higher growth and lower unemployment but the opposite with cost push inflation. Stagflation occurs. Demand side inflation is easier to solve as you can use contractionary fiscal policies
Duration is key. Long term and anticipated can spiral.

Question 20

Causes and consequences of deflation

Answer 20

You have demand side and supply side deflation

Demand side deflation is bad deflation. This is as it comes with lower economic growth. The major issue is that we assume that deflation will be long term and anticipated. Ad shifts left and causes a recession which will last for some time.
Supply side deflation is not so bad as it comes with higher economic growth and this type of deflation is more likely to be short term and unanticipated. This is as factors that shift SRAS can all change very quickly

Anticipated deflation is really dangerous and can lead to a spiral. Rational consumers will delay thwir spending. Why buy now when you know prices gonna fall even more. This means consumption falls which reduces AD. Business slash prices and this makes deflation even worse. When AD falls you get lower growth and higher unemployment. When there is deflation, real interest rates will always be positive. Even if IR at 0%, IR will always be posittive in real term. Let’s say deflation rate is -2%. 0 - - 2 % s +2%. Incentive will be to save instead of borrow and consume as a business. Less consumption again.
Increases real value of debt. If prices fall profits fall but also since delayed spending, firms are not making as much profit. For workers their income falls and also prices falling economy so lower incomes are fine. This makes it harder to service debt

Whether deflation is good or bad all depends on whether deflation is anticipated or not and also the cause whether it is supply or demand side