Inflation

Question 1

Inflation

Answer 1

The sustained increase in general price levels

Question 2

Hyperinflation

Answer 2

The excessive increase in the price level

Question 3

Deflation

Answer 3

A fall in average price level

Question 4

Disinflation

Answer 4

A fall in the rate of average inflation

Question 5

Index numbers and inflation

Answer 5

Index number in Year X = (value in year X / base year value) x 100

Question 6

Consumer Price Index

Answer 6

• measured using a basket of goods that have been weighted and the prices of the good are measured every month
• compared with how much prices have been in the past months
• can make comparisons with other european countries
• it doesn’t include housing tax or council tax
• been criticized because the UK is a developed nation of homes

Question 7

Retail Price Index

Answer 7

• always higher than CPI as includes mortgage payments
• excludes pensionsers and high income households unlike CPI
• excludes 12% of households to get a more representable average

Question 8

Difficulties of measuring inflation

Answer 8

1. Is there a typical household?
   - different individuals spend different amounts of money on different things
   - different families have different consumption patterns
   - doesn’t properly represent inflation
2. Same basket of goods changed
   - very hard for comparisons to be made
   - prices might be increasing because of quality not just inflation
   - estimated that if remove the products that have increased in price due to improvements, inflation only increases by 1%
3. Inflation tends to be overstated
   - do not take into account availability of substitutes
   - do not look at ability for people to move away from the good and by substitutes instead

Question 9

Cost push inflation

Answer 9

Inflation initiated by an increase in costs of production
- such as wages, raw materials etc

Question 10

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What will firms have to do when costs of production increases?

Answer 10

Increase the prices of the goods to maintain profit

Question 11

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Why does cost push inflation tend to be temporary?

Answer 11

Costs of production are very volatile
- cost of raw materials depends on exchange rates as importing from abroad

Question 12

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Demand pull inflation

Answer 12

Inflation initiated by an increase in aggregate demand
- such as increase in wages, incomes, consumption etc

Question 13

Why does the economy experience demand pull inflation?

Answer 13

When there is an increase in AD but supply cannot keep up
- economy is reaching full capacity
- increasing AD eventually reaches the inelastic part of LRAS so there is no change in output but an increase in price

Question 14

Causes of demand pull inflation

Answer 14

1. Decrease in interest rates
2. The wealth effect
3. Increase in money supply

Question 15

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Evaluation of the causes of demand pull inflation

Answer 15

1. Decrease in interest rates
- depends upon how much interest rates decrease by
- information failure
- target savers continue to save same amount
- consumer confidence

2. The wealth effect
- information failure
- may not risk losing asset
- asset prices are volatile
- save money for inheritance

3. Increase in money supply
- banks may not be willing to give out loans
- depends upon if have spare capacity

Question 16

Causes of cost push inflation

Answer 16

1. Increased cost of materials
2. Increase in tax
3. Inflation expectations

Question 17

Evaluation of the causes of cost push inflation

Answer 17

1. Increased cost of materials
- firms might find other substitutes within the UK that are more sustainable
- have signed contracts so will still have to pay regardless

2. Increase in tax
- big firms may not pass this increasing cost to consuemrs due to lots of profit and so able to absorb the cost

3. Inflation expectations
- the government aims to have inflation between1-3%
- because people know that they won’t expect inflation to rise and so won’t demand higher wages
- may use interest rates to keep inflation stable

Question 18

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Causes of both demand pull and cost push inflation

Answer 18

1. Increased wages
2. Devaluation of currency

Question 19

Evaluation of causes of both demand pull and cost push inflation

Answer 19

1. Increased wages
Demand pull:
- depends on how much wages icnrease by
- may choose to save instead

Cost push:
- depends upon how large wages are compared to inflation
- wages may be very small for big firms
- due to technological advancements labor is now becoming insignificant and replaced by capital

2. Devaluation of currency
Demand pull:
- people from abroad might not want UK goods
- depends on what is being consumed and imported
- if is a necessity not in the UK it has to be imported regardless of increase in price

Cost push:
- depends upon how much it depreciates by
- firms may be buying raw materials domestically

Question 20

What does the causes of inflation depend upon?

Answer 20

1. Government Policies
- gov could decrease benefits to incentivize people to come into workforce
- depends on whether other policies are in place at the same time

2. Size of Multiplier
- depends on the size of the multiplier as there might be a lot of leakages
- depends upon how much AD increases by

3. Developed or Developing
- develop nations are able to invest in higher quality capital, so are able to meet increasing demand
- developing countries tend to have higher inflation rates as they hit supply constraints quicker

4. Depends on where the economy is operating on the LRAS
- if on the perfectly inelastic part, inflation won’t occur as a lot of spare capacity in their economy

Question 21

Consequences of Inflation

Answer 21

1. Inflationary expectations
- workers demand higher wages so nominal wage increases in line with inflation, firms cop increase, prices increase, cost push inflation, wage price spiral
- when households expect inflation to increase may forward consunmption and so demand increases, price increases, more inflation

2. Uncertainty
- consumers uncertain whether inflation would continue to increase or decrease and so cannot plan their consumption
- may stop consuming and save, demand decreases so firms less confident to invest
- banks may not give out loans as they are not confident that consumers and firms will be able to pay back and may default

3. Increases income inequality
- high income households still have enough RDY to afford goods when inflation is high whereas takes a larger proportion of income for low income households
- higher income workers, more skilled, demand higher wages, increase in line with inflation as they have higher bargaining power
- low income households rely on benefits as which dont increase in line with inflation

4. Decrease in international competition
- prices are high domestically so domestic consumers start to import cheaper goods
- people from abroad may also stop exporting from the UK as more expensive so less competitive
- imports increase, exports decrease, current account deficit increases

5. Shoe leather costs
- as inflation increases, value of money decreases
- want to minimise their cash holdings as purchasing power goes down sofeel like they need to go to the bank to collect their money and foreward expenditure
- when prices increase, consumers dont know if it is becasues of inflation or the firm increasing prices because quality increased so have to keep walking to different firms

Question 22

Benefits of Inflation

Answer 22

1. Benefits economic growth
- prices higher, firms more incentitvised to supply as more profitable
- need more workers to produce these goods, derived demand for labour increases, unemployment decreases
- wages doesnt increase in line with inflation so incentivises unemployed people to look for work as the work replacement ratio is low so earn more working
- shifts the LRAS curve to the righ, increasing real GDP and economic growth

2. Fiscal Drag
- when inflation and earning growth pushes tax payers to a higher tax bracket without having to actually increase tax brackets
- gov collect more tax revenue, can hypothecate to welfare

3. Real Wage Flexibilty
- when inflation increases, firms increase wages lower than the rate of inflation so gain more in real terms, increase their normal but decreasing their real wage
- workers now under the money illusion, think they are getting paid more but don’t understand that they have a decrease in real terms
- become more motivated and productive, decreases unit labour costs, cop decreases
- worse for developing countries as financially and don’t have trade unions to help them understand

4. Debtors/borrowers will benefit

Question 23

What does inflation depend upon?

Answer 23

1. Rate of inflation
- depends on if its hyper inflation of low and stable inflation

2. Cause of inflation
- beneficial if due to AD shifting as economic growth also increases but bad if SRAS shifting as cost push inflation increases which is the worst type of inflation

3. Inflation in competitor countries
- if inflation is worse in other countries people may still decide to buy domestically as cheaper

4. Government intervention
- the government aims to have inflation between 1-3% so may have policies to oprevent this such as SSP

5. Volatility
- If inflation keeps changing, causes inflationary noise and consumers dont know what to expect and firms become reluctant to invest

6. Nature of good
- inflation is worse if the good is a necessity as no matter how much prices icnrease consumers will still continue to buy the good
- PED inelastic

7. The group being considered
- benefits debtors and those on fixed incomes
- high income earners wont be harmed as high purchasing power so can demand higher wages to increase in line with inflation
- low income households more impacted

Question 24

Causes of deflation

Answer 24

1. Decrease in AD
2. Increase in SRAS
3. Increase in LRAS

Question 25

Disadvantages of deflation

Answer 25

1. Delayed consumption
- expect prices to fall further so delay consumption
- AD decreases, investments decrease, derived demand for labour decreases so unemployment increases
- deflationary spiral

2. Lower profits
- firms will supply less as less profitable
- unemployment increases
- negative knock off effect

3. Value of debt increases
- bad for debtors, good for creditors

4. Real cost of borrowing goes up
- interest rates increase, less people are incentivised to borrow, less firms incentivised to invest

5. Reduced confidence
- value of assets decrease
- when there is deflation, consumers think the economy is not doing well so might save money instead
- firms less confident and reluctant to invest

Question 26

Advantages of deflation

Answer 26

1. Increases international confidence
- prices are now lower for domestic consumers, so imports decrease
- cheaper for people abroad and so exports increase
- overall net exports increase and ad increases

2. Improved standards of living
- people have higher purchasing power, can now buy more with the same amount of money, increased demand

3. Lower income inequality
- narrows the gap between rich and poor
- deflation causes a decrease in value of assets so now lower household can now afford Necessities
- can also now afford assets as value goes down, so wealth inequality also decreases

Question 27

What do the harms of deflation depend upon?

Answer 27

1. Cause of deflation
- shift in LRAS is beneficial as it increases economic growth and non-inflationary
- if it is a continuous shift in AD it is purely inflationary

2. Duration of deflation
- If doesn’t last very long doesn’t have a large impact
- depends on government policies put in place to get rid of deflation
- if SRAS shifts to the right it is not long-lasting as costs of production is very volatile

3. Price of International competitors
- only if prices are lower than international competitors it will be beneficial and more competitive
- other countries may be experiencing a bigger deflation