Week 15 - Inflation

Question 1

Price index

Answer 1

Measures the average price of a given quantity of goods or services relative to the price of the same goods in a base year.

Question 2

Consumer price index (CPI)

Answer 2

A measure of the cost of living over a specified time period.
It measures the cost of a standard basket of goods in a given year relative to the cost of the same basket of goods and services in the base year.

Question 3

Calculating CPI

Answer 3

Find CPI by finding the ratio of the cost of the current year’s standard basket of goods to the cost of the base year.
CPI = currentYear/baseYear * 100

Question 4

Consumer expenditure survey

Answer 4

The method of data collection for the data used to calculate CPI.

Question 5

Meanings of CPI values

Answer 5

If CPI = 100, prices have remained the same as in the base year.
If CPI > 100, prices have increased (inflation).
If CPI < 100, prices have decreased (deflation).

Question 6

Inflation

Answer 6

Measures how fast average price levels are changing over time.
A normal level of inflation is around 2-3%.

Question 7

Rate of inflation

Answer 7

The annual percentage rate of change in the price level.

Question 8

Deflation

Answer 8

A situation in which most goods or services are falling over time - inflation is negative.

Question 9

Nominal and real quantities

Answer 9

Nominal quantity: measured in terms of its current dollar value.
Real quantity: measured in physical terms quantities of goods and services.
Real quantities are used to compare values over time as they hold price constant meaning the quantity is not affected by inflation.
Real quantity is found by dividing a nominal quantity by its price index.

Question 10

Real wage

Answer 10

The wage paid to the worker measured in terms of purchasing power.
The real wage for a time period is found by diving nominal wage by CPI for that time period.

Question 11

Indexing

Answer 11

Increasing a nominal quantity each period by the percentage increase in a specified price index.
This allows for some values to be automatically adjusted by the amount of inflation. E.g., social security payments or labour contracts.
Indexing prevents the purchasing power of the nominal quantity being eroded by inflation.

Question 12

Minimum wage

Answer 12

The minimum amount workers are legally allowed to be paid.
This is set by congress in nominal terms however it is argued that changing minimum wage by indexing could be simpler and less controversial.
It is agreed that increasing minimum wage can lead to inflation however some argue that small increases does not cause inflation while others argue any increase in minimum wage leads to inflation.

Question 13

Tight labour markets

Answer 13

A situation where there are low levels of unemployment and also high levels of job vacancies.
Tight labour market is a sign of a strong economy but, if left unchecked, it can lead to higher inflation and potential wage-inflationary spirals.

Question 14

How can tight labour markets lead to inflation

Answer 14

In tight labour markets, employers must compete for workers, often through higher salaries.
Higher salaries in tight labour markets increases disposable income which increases demand, putting upward pressure on prices, leading to inflation.

Question 15

CPI limitations

Answer 15

• Hard to add new items - new items do not exist in the base year so cannot be compared.
• CPI may overstate cost of living because it is based on a fixed basket of goods and services.
• Quality bias: It is hard to measure changes in the quality of products with CPI as there are many goods and quality change can be subjective.
• Substitution bias: When prices go up, people can substitute on good for another. Failing to account for substitution in CPI calculations can cause inflation to be overstated.

Question 16

GDP price deflator

Answer 16

Measures the changes in prices for all of the goods and services produced in an economy.
More comprehensive than CPI as it represents total output of goods and services, not just a fixed basket of goods.
Allows changes in consumption patterns or the introduction of new goods and services to be automatically included.
GDP price inflator captures how much of nominal GDP increase is due to price changes and how much is increases of quantity of goods/services produced.

Question 17

GDP price deflator formula

Answer 17

GDP price deflator = Nominal GDP/ Real GDP * 100

Question 18

Price level

Answer 18

A measure of the overall level of prices at a particular point in time as measured by a price index such as the CPI.

Question 19

Relative price

Answer 19

The price of a specific good or service in comparison to the prices of other goods and services.
E.g., if inflation rate is 2% but light bulbs increase by 1%, there has been a 1% relative decrease in relative price of light bulbs.
Increasing relative price encourages consumers to save money on expensive products and search for their substitutes.
Increasing relative price encourages companies try to bring more products to the market to gain profit.

Question 20

Bracket creep

Answer 20

Bracket creep: non indexed taxes create distortions in tax incentives because as inflation rises, taxpayers may end up paying higher taxes from increased nominal income even if their real income has not increased. This can reduce incentives for people to work, save, and invest.
Lower savings and investment from bracket creep decreases economic growth.

Question 21

Effect of inflation on cost of cash

Answer 21

When inflation is high, cash loses its value over time. This means people are likely to make more frequent, smaller transactions to get cash at the highest value.
The more frequent trips cost consumers on time and travel and costs banks on increased transaction costs.

Question 22

Effect of inflation on wealth distribution

Answer 22

Unexpected inflation and un-indexed salaries cause salaries to lose purchasing power and employers to gain at the expense of workers.
Unexpected inflation can benefit borrowers at the expense of lenders as borrowers repay with money that is worth less than when it was borrowed.

Question 23

Effect of inflation on long term planning

Answer 23

Erratic inflation can make long term planning risky.
E.g., retirement requires long term planning as by saving too much you live less well now but by saving too little now, you live less well in the future.

Question 24

Menu costs

Answer 24

Costs of adjusting prices.
Need to update prices lists and other prices during inflationary times however this is resource and time consuming.
Prices adjust with a delay and don’t always move in line with changing economic conditions

Question 25

Real and nominal interest rate

Answer 25

The annual percentage increase in the purchasing power of financial assets. Fisher equation: r = i - π Real interest rate = nominal interest rate - inflation The annual percentage increase in the dollar value of an asset Higher interest rates means households and firms spend more on interest debt payments, leaving them with less money to spend on anything else

Question 26

Demand pull inflation

Answer 26

When government increases spending, causing increased demand for goods and services, which can lead to higher prices. If supply cannot keep up with the increased demand, prices rise leading to inflation.

Question 27

Monetary inflation

Answer 27

Governments can finance its spending through borrowing or printing money however this increase in the money supply can lead to a decline in the value of money, which can also result in inflation

Question 28

Transfer payments

Answer 28

Spending on transfer payments can increase demand without increasing supply which can lead to higher inflation.

Question 29

Spending on infrastructure

Answer 29

Government spending on infrastructure and other productive investments can increase the supply of goods and services, which can help to counteract inflationary pressures.

Question 30

Effects of inflation on the government

Answer 30

Increased inflation causes increased cost of borrowing for the government as lenders demand higher interest rates to compensate for decline in moneys value. This can limit the ability to finance spending through borrowing as this increases the budget deficit. Inflation can affect governments revenue as it reduces real tax values and other income sources. This means the government can have to cut spending or increase borrowing. Increased transfer payments and welfare benefits indexed to cost of living places upward pressure on budget deficit unless taxes are adjusted accordingly.

Question 31

Stagflation

Answer 31

A phenomenon in which an economy experiences both high inflation and stagnant economic growth at the same time. Typically occurs when there are supply-side shocks to the economy, such as an increase in the price of oil or other important inputs, which push up prices while also reducing economic growth and increasing unemployment.

Question 32

Addressing stagflation

Answer 32

Can be difficult to address because monetary policy, which would usually be used, is less effective when prices are rising. Fiscal policy, such as increasing government spending, can be less effective as well because it can lead to higher inflation which adds to the problem. Reversing high consumer prices requires government to balance slowing the economy just enough to ease consumer demand but without falling into a recession or triggering stagflation.