Week 2- Inflation Flashcards
What does inflation tell us at a basic level?
Inflation tells us about the rate at which prices in the economy are changing
Who monitors inflation in the UK?
Inflation is closely monitored by the Bank of England
How does inflation affect households?
On the household side, inflation affects the purchasing power of our:
- savings
- utility bills
- prices we pay for the weekly shop
How does inflation affect firms?
For firms, inflation matters because it affects the cost of inputs such as petrol and electricity
If inflation is relatively high, firms will update their prices more frequently to prevent their profit margins being ‘squeezed’ by higher costs
Define inflation
Inflation is defined as the percentage change in the general price level over a given period of time
For example, if the price level were to increase from 100 to 110 in the next year, this would amount to an annual inflation rate of 10%
How do you calculate inflation?
Inflation rate = [(price level this period - price level last period) / price level last periods] x 100
Essentially new minus original over original price level
What is price level and how does it help us calculate the inflation rate?
The price level is a measure of the average level of prices in the economy
The price level tells us whether the prices of goods and services have generally been rising, falling, or steady over a given period of time
Since the price level is difficult to interpret, we focus instead on its rate of change: inflation
What can price level also be referred as?
The price level is sometimes referred to as the ‘general price level’ or the ‘aggregate price level’ to distinguish it from the prices of individual goods and services
Why is price level/general price level/aggregate price level on its own difficult to interpret and why is inflation a better measure?
For example, if you were told the price level is 124, it is hard to know what that means without having some reference point, such as the information that it was equal to 121 one year ago
By focusing on inflation we build in a reference point without having the trouble of remembering what the past price level was
What is inflation an indicator and how does it indicate that?
Inflation is an indicator of the economy’s temperature
When inflation is relatively high, this indicates that our demand for goods and services outstrips our ability to produce them. Since extra production takes time, the only way for demand to be rationed to the available supply is for the prices to increase. In this case, the economy’s temperature is rising
Conversely, negative inflation – known as deflation – indicates that demand for goods and services falls short of production. To prevent a build up of unsold inventories, firms will reduce the prices of goods and services in what amounts to an economy-wide ‘stock clearance’. The economic temperature is then falling
What is the ideal amount of inflation and ideal economy temperature?
We would ideally like to have just a small amount of inflation, so that the economy’s temperature is stable – it rises at a slow and controlled rate
What equation can be used to understand the average inflation rates across countries?
Inflation bar (horizontal line over the top of inflation to indicate average inflation rate) = ∆%M bar (horizontal line over the top of M to indicate average rate of money supply growth) – ∆%Y (horizontal line over the top of Y to indicate average rate of real GDP growth)
… average inflation rate = change in the average rate of money supply growth – the change in the average rate of real GDP growth
What does the average inflation rate equation tell us?
The average inflation rate equation says that high money supply growth will produce high inflation. However, the tightness of this link depends on economic growth
For example, if the money supply is growing at 10% a year and real GDP growth is 3%, inflation will average 7% per year
Equation (1) is a good predictor of average inflation over several decades
What is the link between inflation and money supply growth?
As the money supply increases, inflation also increases (there is a strong positive correlation between the two- seen in graph which shows the relationship between inflation and money supply growth in 110 countries from 1960-1990- see image in notes)
Explain the link between inflation and money supply growth and therefore the economic intuition behind the average inflation rate equation
If the Bank of England turns on the printing press, commercial banks will have additional money to loan out to customers
This additional money in the form of bank loans to households and firms provides the private sector with extra purchasing power: it has the ability to buy more goods and services at current prices
If our demand for goods and services outstrips our ability to supply them, prices will start to rise and we get inflation. This is exactly what Equation (1) says: money growth in excess of real GDP growth gives a positive inflation rate
