2.1.2 Inflation

Question 1

Define Inflation, Deflation, and Disinflation

Answer 1

1. Inflation: the sustained increase in the general price level of goods and services in an economy over time. It leads to a decrease in the purchasing power of money.
2. Deflation: the opposite of inflation, characterized by a sustained decrease in the general price level. It increases the purchasing power of money but can discourage spending and investment.
3. Disinflation: when the rate of inflation declines but remains positive. Prices are still rising, but at a slower rate than before.

Question 2

How do you calculate the Rate of Inflation Using the Consumer Prices Index (CPI)?

Answer 2

1. Consumer Prices Index (CPI): a widely used measure of inflation in the UK. It tracks changes in the prices of a basket of goods and services purchased by an average household.
2. Calculating CPI Inflation:
   CPI Inflation Rate = [(Current CPI - Previous CPI) / Previous CPI] × 100.

Question 3

What are the Limitations of CPI in Measuring Inflation?

Answer 3

1. Substitution Bias: CPI assumes constant consumption patterns, whereas consumers often adjust their purchases in response to changing prices. This can lead to an overestimation of inflation.
2. Quality Changes: CPI may not adequately account for quality improvements in goods and services over time. This can result in an overestimation of price increases.
3. Household Survey Participation: The Living Costs and Food Survey (LCFS), which provides essential data for CPI calculations, has experienced a significant drop in participation:​ In 2000, the response rate was approximately 60%. By 2023, this had fallen to just 22%.​ This decline raises concerns about the representativeness of the data used to calculate inflation. ​Certain demographics or regions might be underrepresented, skewing the data.

Question 4

What is an alternative measure of inflation?

Answer 4

Retail Prices Index (RPI): includes a broader range of expenditures than CPI. It is used for various purposes, including index-linked bonds and some pension calculations. Differences from CPI: RPI tends to produce a higher inflation rate than CPI because it includes housing costs and uses a different formula.

Core inflation tracks how prices are rising across the economy, leaving out food and energy, since the prices of those items tend to swing unpredictably. It is commonly calculated using the consumer price index (CPI) and the core personal consumption expenditures (PCE) index.

Question 5

What are 3 Causes of Inflation?

Answer 5

1. Demand-Pull Inflation: when aggregate demand exceeds aggregate supply, leading to upward pressure on prices. Factors like increased consumer spending, business investment, or government expenditure can contribute to demand-pull inflation. E.g. An economic boom that stimulates consumer spending and business investment may result in demand-pull inflation.
2. Cost-Push Inflation: arises when production costs increase, causing firms to raise prices to maintain profitability. Factors like rising raw material prices, higher wages, or supply chain disruptions can lead to cost-push inflation. E.g. A spike in oil prices can trigger cost-push inflation as it raises production costs for many goods and services.
3. Growth of the Money Supply: An increase in the money supply, not matched by a corresponding increase in economic output, can lead to excess demand for goods and services and result in inflation. E.g. Central banks printing excessive amounts of money can contribute to inflationary pressures.

Question 6

What are some Effects of Inflation on Economic Agents?

Answer 6

1. Consumers: Inflation erodes the purchasing power of money, reducing the real value of savings. Fixed-income earners may experience reduced real incomes. People on fixed pensions may find it more challenging to maintain their standard of living.
2. Firms: Firms may face rising production costs, reducing profit margins. They may adjust prices upward to maintain profitability.
3. Government: Inflation can decrease the cost of servicing government debt, if the interest rate is fixed, if variable then an increase in interest to combat inflation can increase the cost of servicing the debt . Tax brackets may not be adjusted for inflation, resulting in “bracket creep” and higher tax burdens.
4. Workers: While workers may see nominal wage increases, their real wages may decline due to inflation. Labor unions may negotiate for higher wages to keep pace with rising prices.