3.5 - Inflation

Question 1

Define ‘inflation’

Answer 1

Sustained increase in the general price level in an economy

Question 2

Methods to calculate inflation?

Answer 2

Measured by CPI (Consumer price index) and RPI (retail price index)

Question 3

Definite index number

Answer 3

A figure reflecting price or quantity compared with a base value.

Question 4

Define CPI

Answer 4

Measure of the general price level in the UK

Question 5

Limitation of CPI

Answer 5

1. Unusual spending habit (different people spend differently)
2. Time lag (only updates once a year)
3. Changes in quality (might be priced higher at a higher quality)

Question 6

Alternative measurement of inflation

Answer 6

RPI - measure of average level of price in uk

was replaced with CPI due to EU countries using CPI, allowing fairer comparisons.

CPI measured effects of microeconomic policy changes more effectively

Question 7

Similarities and differences between CPI and RPI

Answer 7

Similarities: both measured overall price level at different time points
Both indices show how general price level changed relative to the base year

Differences: RPI includes housing costs (mortgage interest payments, council tax, estate agent fees. CPI does not, underestimating inflation.

RPI excludes highest and pensioner households (dependent on benefits) = higher rate than CPI

CPI includes university tuition fees, more modern.

Question 8

Causes of inflation

Answer 8

1. Cost-push inflation (caused by increase in COP eg wage faced by firms, arising on the supply side of the economy, price increases to maintain profit margins)
2. Demand-pull inflation (caused by an increase in AD)
3. Increase in money supply, (quantity of money increases) lowered interest rate, more spending

Question 9

Consequences of inflation

LCUUPF

Answer 9

1. Less competitive abroad (higher COP -> higher price -> less competitive for exports)
2. Uncertainty for firms’ planning and investing (cautious of spending, cut back on investing, lead to fall in AD)
3. Unemployment (due to lack of competition and uncertainty, greater inequality)
4. Purchasing power fall (those with fixed income will have less purchasing power, standard of living decreases)
5. Fiscal drag, workers with increased income will pay more taxes

Question 10

Why does the bank aim for 2% inflation rate as oppose to 0%?

Answer 10

Inflation indicates rising demand in the economy, and that increase in supply is keeping up with the increase in demand. Shows growth in economy.

Firms do not cut price and wages as may demotivate workers

Low and stable rate, expected by agents can act as effective signal to the economy,

Question 11

Problems of deflation CCBP

Answer 11

1. Consumers postpone consumption to expect price fall further
2. Consumer confidence drops and savings rise (price in housing decreases, consumers refuses to purchase, fear of losing value) further decline of AD and rise in savings
3. Real cost of borrowing increases (nominal rates do not fall with deflation, cost of borrowing increases, lead to less borrowers, fall in AD)
4. Lower profit margin (profits margins under pressure unless cost decreases, lead to unemployment due to cutting COP, lower profit margin also leads to negative effect on stock market due to fall profits to stockholders and dividends)

Question 12

Define deflation

Answer 12

Persistent fall in the average price level, negative inflation

Question 13

Define disinflation

Answer 13

Fall in the rate of inflation

Question 14

Define stagnation

Answer 14

Situation where unemployment and inflation are high