Inflation

Question 1

Definition of inflation

Answer 1

A persistent or continuing rise in the average price level
- originates from the Latin inflare (to blow into or inflate)

Question 2

Why is inflation always related to the value of currency itself

Answer 2

because it directly impacts the purchasing power of that currency

Question 3

Inflation in commodity money vs fiat money

Answer 3

• commodity money is generally more resistant to inflation because its value is tied to a tangible asset
• Fiat money, lacking intrinsic value, relies on the responsible management of the money supply by central authorities to maintain its value and avoid the negative effects of inflation

Question 4

Long term Inflation trends

Answer 4

• Since the Great Depression there has been a general tendency for prices to rise every year. In the 1970s and early 1980s, annual inflation in most industrialized countries reached two digits

Question 5

Price indices inflation

Answer 5

• Broad: said to measure the economy’s GPL or CoL (CPI and PCEPI)
• Narrow: can help producers with business plans and pricing, and guiding investment (PPI and ECI)

Question 6

The Price Revolution

Answer 6

• The exploration and colonization of the Americas brought a significant influx of precious metals, particularly silver and gold, to Europe. This increase in the money supply contributed to inflationary pressures.

Question 7

Demand pull inflation

Answer 7

• A rising price level caused by an increase in AD
• AD outpaces AS
• often associated with a wage-price spiral
• If the central bank pursues an expansionary monetary policy AD will increase
• more likely to occur when an economy is operating near or at its full capacity: limited supply means firms respond to increased demand by putting prices up

Question 8

Why do prices rise as when output rises

Answer 8

• If the economy is producing below the normal capacity level of output the price level has to rise in order to persuade firms to produce more output.
• This is because producing more goods incurs higher costs so to maximise profit firms need reward.

Question 9

Keynes on inflation.

Answer 9

-Unlikely to occur in a negative output gap as there is room for expansionary policies to stimulate demand without necessarily causing inflation
- However, there is a tradeoff between inflation and unemployment (Philip’s Curve) & therefore policymakers should accept a temporary higher inflation rate in return for boosting AD
- Focuses on demand-pull inflation. Does not really have an answer for cost push inflation. By adjusting fiscal and monetary policies, governments can influence overall demand in the economy but not really supply

Question 10

Keynes on trade-off between inflation & unemployment

Answer 10

Keynesian theory suggested that the immediate priority should be to address high unemployment and under-utilized resources. Even if increasing government spending led to a moderate level of inflation, Keynes argued that it was a preferable trade-off compared to the social costs of widespread unemployment. In the long run, the economy would adjust, and the benefits of full employment would outweigh the temporary inflationary pressures.

Question 11

How is inflation calculated

Answer 11

• Most commonly brought G&S for a year are compared to their price from last year
• Last years total indexed to 100
• Change is shown via an index No.
• Larger the proportion of people’s income is taken up buying an item, the larger the weight it has on the final index No.

Question 12

The Living Costs and Food Survey (LCF)

Answer 12

• most significant survey on household spending
• ## collects information on spending patterns and the CoL that reflect household budgets

Question 13

Why are consumers interested in inflation

Answer 13

• Higher inflation can lead to a reduction in real income
• High inflation encourages hoarding
• Consumers need to account for the potential increase in CoL when making long-term financial decisions
• Inflation affects the real value of savings. If the rate of inflation is higher than the return on savings, the purchasing power of saved money decreases over time.
• Deflation encourages consumers to hold off purchasing as things will be cheaper in the future.
• Consumers monitor inflation to anticipate potential changes in interest rates

Question 14

Why are businesses interested in inflation

Answer 14

• Rising prices of raw materials, labour, and other inputs can increase production costs
• High inflation may lead to more cautious investment decisions
• Inflation can squeeze profit margins if businesses are unable to pass on increased costs to consumers
• Inflationary pressures can disrupt supply chains, important in ensuring a stable and efficient production process

Question 15

Why is the Government interested in inflation

Answer 15

• Excessive inflation makers it more difficult to maintain price stability
• Influences their costs (pensions, public pay, benefits) & tax revenue (VAT goes up because prices are higher)
• High and unpredictable inflation can lead to social unrest and political instability
• interested in managing inflation to support a stable exchange rate and enhance international trade
• Inflation can affect the real value of national debt
• Gov’s ability to manage inflation effectively contributes to its overall economic credibility; increases investment

Question 16

Why are workers and trade unions interested in inflation

Answer 16

• Inflation affects the real purchasing power of wages. If wages do not keep pace with the rising cost of living, the real value of workers’ incomes decreases. Workers and trade unions are concerned about maintaining or improving real wages to ensure that their members can afford essential goods and services
• inflation rate informs negotiations for wage increases

Question 17

If inflation lowers standards of living for the population, why would this have a bigger impact on low income families

Answer 17

• limited financial resources, so when cost of essentials rise, they find it harder to absorb price increases
• Limited access to credit
• Low-income families often lack a financial cushion or savings to buffer against economic shocks. Inflationary pressures can lead to sudden and unexpected increases in the cost of living
• Housing costs, tend to be a significant portion of low-income families’ budgets. Rising housing costs makes it challenging for these families to find affordable and stable housing
• Low-income families may have limited opportunities for investments that can act as a hedge against inflation. Unlike higher-income households that may have diversified investment portfolios, low-income families may primarily rely on income from employment, making them more vulnerable to the direct impact of rising prices

Question 18

Fiscal drag

Answer 18

• the process by which inflation pushes wages and salaries into higher tax brackets
• In UK tax thresholds have been frozen since April 2021
• Freeze is expected to last to 2028: OBR estimates additional £26bn to be raised
• Most progressive tax systems are not adjusted for inflation. As wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate.
• One cause of fiscal drag may be bracket creep

Question 19

Asset price inflation

Answer 19

• economic phenomenon whereby the price of assets rise and become inflated
• common reason is low interest rates
• Example is the housing market: house prices have over the past 25 years consistently risen far above that of the CPI
• often followed by an asset price crash: Dutch tulip, Japanese asset price bubble, 2007 subprime mortgage financial crisis

Question 20

Hoarding

Answer 20

…
- defined as acquiring a good, service or asset in excess of immediate needs

Question 21

The Great Moderation

Answer 21

• mid 80s - 2007
• reduction in the volatility of business cycle fluctuations in developed nations
• primarily due to greater independence of the central banks
• e.g. the Taylor rule

Question 22

Positive of inflation in regards to wage stickiness

Answer 22

Inflation decreases the real value of wages, in the absence of corresponding wage rises. In the theory of wage stickiness, a cause of unemployment in recessions and depressions is the failure of workers to take pay cuts, to decrease real labour costs. It is observed that wages are nominally sticky downwards, even in the long term (it is difficult to reduce nominal pay rates), and thus that inflation provides useful erosion of real costs wages without requiring nominal wage cuts.

Question 23

Inflation Control as a Means, Not an End

Answer 23

• primary goal is not merely the control of inflation for its own sake but the establishment of “sound money.”
• Inflation control contributes to a predictable economic environment to maintain economic stability
• When individuals and businesses have faith in the stability of their currency, it enhances overall economic stability

Question 24

Sound money

Answer 24

• implies a stable and reliable monetary system where the value of the currency remains relatively constant over time
• Sound money encourages savings by providing a reliable store of value.
• In a system with sound money, businesses, consumers, and investors can make decisions based on a more predictable and stable economic landscape.
• A stable monetary environment ensures that prices reflect real supply and demand conditions, facilitating efficient resource allocation and preventing distortions caused by rapid changes in the value of money.

Question 25

How important is confidence in a currency

Answer 25

• Confidence in a currency serves as the bedrock upon which monetary systems are built. A currency is essentially a social contract, a representation of value that requires widespread trust and acceptance. Without confidence, the entire monetary system becomes vulnerable to instability and loss of functionality.
• stability fosters trust in the value of money, supporting both short-term transactions and long-term planning.
• Currencies that are perceived as safe havens tend to attract capital during crises, reflecting a flight to safety driven by confidence in the currency’s stability.

Question 26

Quotes on the Relationship Between Confidence and Inflation:

Answer 26

• “Inflation erodes the purchasing power of a currency, but it is the erosion of confidence that can unravel an entire monetary system. Managing inflation is not just an economic necessity; it is a measure of maintaining public trust.” - [Central Banker]
• “The delicate balance between inflation and confidence is the heartbeat of economic stability. Lose one, and the other falters.” - [Economic Theorist]
• “Inflation may be a monetary phenomenon, but its impact is deeply psychological. Managing inflation is not just about numbers; it’s about maintaining the psychological stability of the currency.” - [Policy Economist]

Question 27

Oil Crisis (1970s):

Answer 27

• The Organization of the Petroleum Exporting Countries (OPEC) imposed oil embargoes and raised oil prices significantly. This led to a surge in production costs across various industries and contributed to inflation.
• In 1973, the year of the oil crisis, the UK’s inflation rate soared to around 9.3%.
  By 1975, inflation had reached double digits, peaking at approximately 24.2%.
• combination of increased production costs, reduced aggregate supply, and expansionary fiscal policies to counter economic downturns contributed to demand-pull inflation during this period.

Question 28

Lawson Boom (1980s):

Answer 28

• In the 1980s, Chancellor Nigel Lawson pursued expansionary fiscal policies to stimulate economic growth. Tax cuts, particularly in income tax, and increased public spending were implemented.
  -In 1986 CPI was 3.6%. In 1988, inflation spiked to approximately 7.8%
• The Lawson Boom led to increased demand, particularly in the housing market and consumer spending. The combination of loose monetary policy and fiscal stimulus contributed to demand-pull inflation during this period.

Question 29

Post-World War II Reconstruction (1940s-1950s):

Answer 29

The expansionary fiscal policies pursued to finance the reconstruction, along with the release of wartime savings (pent-up demand from wartime austerity measures), contributed to robust consumer spending.

Question 30

Is hyperinflation usually demand-pull or cost push inflation

Answer 30

Hyperinflation is demand-pull because it is primarily driven by an excessive increase in the demand for goods and services, often fueled by factors such as rapid expansion of the money supply, loss of confidence in the currency, and speculative behavior. In hyperinflationary environments, the surge in demand outpaces the economy’s ability to supply goods and services, leading to a rapid and unsustainable increase in prices.
- ie. Weimar Germany

Question 31

Cause of inflation: increased AD

Answer 31

• Point: Demand-pull inflation arises when the overall demand for goods and services surpasses the productive capacity of an economy
• Explain: This heightened demand is often spurred by factors such as a surge in consumer spending, increased government expenditures, or elevated business investments
• Application: Lawson boom

Question 32

Causes of inflation: rising production costs

Answer 32

Explain: Cost-push inflation is characterized by an increase in the costs of production, including wages and raw materials. When businesses face higher costs, they often pass these on to consumers in the form of higher prices for goods and services.
- Application: Oil Crisis 1970s

Question 33

Geoffrey Howe on inflation in 1982

Answer 33

“Inflation is a great moral evil. Nations which lose confidence in their currency lose confidence in themselves.”

Question 34

ONS; Consumer price inflation, UK: April 2024

Answer 34

• rose by 2.3% in the 12 months to April 2024, down from 3.2% in the 12 months to March
• On a monthly basis, CPI rose by 0.3% in April 2024
• Core CPI (excluding energy, food, alcohol and tobacco) rose by 3.9% in the 12 months to April 2024
• Driven by the sharp fall in the energy price cap in April
• prices of electricity, gas and other fuels fell by 27.1% in the year to April; biggest fall since records began 1989

Question 35

Service inflation

Answer 35

Service inflation looks only at the service-related categories like education, hospitality and culture. By breaking down CPI to only look at services, economists can look closely at the different forces that influence this type of inflation. For example, labour market and unemployment has been shown to play more of a role in service inflation compared to goods inflation.

The UK is a majority service-based economy, meaning most jobs revolve around providing services rather than creating products. This means that service inflation has a large influence on overall inflation.

Question 36

Global and domestic causes of high inflation in the past feww years

Answer 36

strong global demand for consumer goods – a consequence of the Covid-19 pandemic and associated lockdowns
related supply chain disruption
soaring energy and fuel prices – particularly, but not exclusively, due to Russia’s full-scale invasion of Ukraine in February 2022.

mainly due to international factors. As the UK is a large net importer of goods (including energy), these global factors affected consumer prices in the UK.

Question 37

hysteresis effect with regard to inflation

Answer 37

High inflation influences inflation expectations and so high inflation tends to cause high inflation in the future. Similarly, low inflation tends to cause low inflation.