2.1.2 Inflation Flashcards
(24 cards)
What is inflation?
It is the sustained rise in the general price level over time.
This means that the cost of living increases and the purchasing power of money decreases.
What is deflation?
It is the opposite of inflation, where the average price level in the economy falls. There is a negative inflation rate.
What is disinflation?
It is the falling rate of inflation. This is when the average price level is still rising, but to a slower extent.
This means goods and services are relatively cheaper now than a year ago for example, and the purchasing power of money has increased.
What do deflationary government policies aim to do?
To reduce AD (aggregate demand), and do not necessarily result in deflation.
How is the rate of inflation calculated in the UK?
Using the Consumer Prices Index (CPI).
What is the Consumer Prices Index (CPI)?
It measures household purchasing power with the Family Expenditure Survey. The survey finds out what consumers spend their income on. From this, a basket of goods is created. The goods are weighted according to how much income is spent on each item. Petrol has a higher weighting than tea for example. Each year, the basket is updated to account for changes in spending patterns.
What is the inflation objective for the UK?
For inflation to be at 2% or -1%.
This is to maintain price stability.
What are the limitations of CPI when measuring inflation?
- The basket of goods is only representative of the average household.
- Different demographics have different spending patterns. The inflation basket contains petrol and cigarettes, yet not everyone in the UK drives or smokes. (Figures are only averages).
- CPI is slow to respond to new goods and services, even though it is updated regularly. It is hard to make historical comparisons, due to technological advancements for example.
- Housing costs account for about 16% of the index, and this varies between people.
What is the Retail Price Index (RPI)?
It is an alternative measure of inflation. Unlike CPI, RPI includes housing costs, such as payments on mortgage interest and council tax.
What are real values?
Real values are adjusted for inflation.
What are nominal values?
Nominal values are not adjusted for inflation.
What are constant prices?
Constant prices consider inflation.
What are current prices?
Current prices do not consider inflation.
What are the three types of causes of inflation?
- Demand pull
- Cost push
- Growth of the money supply
What is demand pull inflation?
It is from the demand side of the economy. When demand is growing unsustainably, there is pressure on resources. Producers increase their prices and earn more profits. It usually occurs when resources are fully employed.
What are the main triggers for demand pull inflation?
- A depreciation in the exchange rate, which causes imports to become more expensive, whilst exports become cheaper. This causes AD to rise.
- Fiscal stimulus in the form of lower taxes or more government spending. This means consumers have more disposable income, so consumer spending increases.
- Lower interest rates makes saving less attractive and borrowing more attractive, so consumer spending increases.
- High growth in UK export markets means UK exports increase and AD increases.
What is cost push inflation?
It is from the supply side of the economy, and occurs when firms face rising costs.
What are the main triggers for cost push inflation?
- Changes in world commodity prices can affect domestic inflation. For example, raw materials might become more expensive if oil prices rice. This increases costs of production.
- Labour becomes more expensive.
- Expectations of inflation. If consumers expect prices to rise, they may ask for higher wages to make up for this, and this could trigger more inflation.
- Indirect taxes could increase the cost of goods such as cigarettes or fuel, if producers choose to pass the costs onto the consumer.
- Depreciation in the exchange rate, which causes imports to become more expensive and pushes up the price of raw materials.
- Monopolies, using their dominant market position to exploit consumers with high prices.
What is the link between growth of the money supply (quantitative easing) and inflation?
If the money supply grows faster than overall economic growth/output, inflation will occur.
What is the impact of inflation on firms?
- Low interest rates means borrowing and investing is more attractive than saving profits. With high inflation, interest rates are likely to be higher, so the cost of investing will be higher and firms are less likely to invest.
- Workers might demand higher wages, which could increase the costs of production for firms. This could cause inflation to increase further, since firms have to put up prices to make up for the higher costs of labour.
- Firms may be less price competitive on a global scale if inflation is high. This depends on what happens in other countries, though.
- Unpredictable inflation will reduce business confidence, since they are not aware of what their costs will be. This could mean there is less investment.
What is the impact of inflation on workers?
- Real incomes fall with inflation, so workers will have less disposable income.
- If firms face higher costs, there could be more redundancies when firms try and cut their costs.
What is the impact of inflation on consumers?
- Those on low and fixed incomes are hit hardest by inflation, due to its regressive effect, because the cost of necessities such as food and water becomes expensive. 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 does not increase with inflation, so the real value of debt decreases.
What is the impact of inflation on the government?
- Pressure to raise the value of state welfare benefits including the state pension or out of work benefits.
- High inflation can cause GDP growth to slowdown, leading to lower tax revenues and increased borrowing.
What are the benefits of inflation?
- If it is low and stable demand pull inflation, it may encourage firms to increase output.
- If pay rates rise, workers feel valued and are more productive.
- If demand is falling, firms can avoid redundancy by not increasing wages by the inflation rate.
