Inflation - A-Level Economics
Inflation
Inflation is a sustained rise in the general price level.
Deflation is a sustained fall in the general price level.
Disinflation is when the rate of inflation slows (prices increase, but at a slower rate).
The inflation rate is defined as the rate of change of the general price level over a period of time.
A good economy tends to have a constant inflation rate, which ensures that the economic environment stays stable, allowing markets to operate efficiently.
How is inflation calculated in the UK?
Increases in the cost of living are measured using an index based on a weighted basket of goods and services. A price survey and a family expenditure survey are used.
Consumer Price Index (CPI)
Consumer Price Index is a measure of the general level of prices in the UK based upon a basket of 650 common household goods, each contributing to the overall price level proportional to their share in consumer expenditure.
CPI has been used by the government to set their inflation target since 2004. Two survey needs to be taken:
- Family Expenditure Survey-‐ this is a survey using information from a sample of 7,000 households in the UK. The households fill out a diary describing what they spent on food, clothing etc. The proportion of income spent on each item is used to give each item a weighting.
- Price survey-‐ this survey involves collecting data about changes in the price of the 650 most commonly used goods and services. Because similar items can be bought in both expensive and cheap shops, a selection of prices are gathered for each item. The price changes are multiplied by the weights to give a price index.
Inflation can be measured by calculating the percentage change in the index over consecutive years.
Exam Tips: Inflation
- Both CPI and RPI are a measure of the general price level-‐ they are not the rate of inflation. The rate of inflation is found by calculating the % change in the general price level.
- The inflation rate may fall, even though the general price level is still increasing. This is because the general price level may just be increasing at a slower rate (disinflation).
Assessing the Inflation Measures
Differences between CPI and RPI
Consumer Price Index measures changes in the price of goods and services purchased by households. CPI is calculated using a defined basket of consumer goods and services. The annual percentage change in the CPI is used as a measure of inflation.
Retail Price Index is also used to measure inflation based on the percentage change in the cost of a basket of retail goods and series. However, RPI includes more variables-‐ such as council tax and mortgage interest repayments, which the CPI does not. Also, the CPI excludes pensioner households and the lowest and highest-‐income households.
CPI is the measure currently used by the UK government, who target an inflation rate of 2%. The Monetary Policy Committee (MPC) works to keep inflation near 2%, and at least between 1-‐3%.
Problems with CPI
Unrepresentative for certain people
- The top and bottom 4% income brackets are not included, nor are pensioners. Therefore the measure is not representative for them.
- For people with atypical spending patterns, such as vegetarians and non-‐drivers, the CPI is unrepresentative (e.g. meat and petrol costs form a large part of normal expenditure)
- No family has exactly the same spending habit as the basket of goods, so to some extent the measure is unrepresentative for everyone!
Sampling Problems
- Many households do not reply to the survey and those who do might not give accurate information about all of the members within the household.
- There are difficulties in obtaining accurate information on prices.
Changes in taste and fashion
- The items in the basket are only changed once a good, but tastes and fashions change more quickly than this.
Substitute Effect
- If a price of a good increases, consumers might substitute it for another cheaper, alternative product. The index does not pick up on this effect because the goods in the basket are only changed once a year, so the price level is often overstated.
Quality Changes
- When the quality of a good changes, the measure breaks down because you are no longer comparing like to like. For example, a mobile phone in 2012 may cost more but this is not due to inflation, this is due to better technologies in the 2012 phone.
Mortgage Interest Repayments
- CPI does not take into account mortgage interest repayments even though they form a large part of household expenditure.
Problems with RPI
Mortgage Interest Repayments
- RPI accounts for the cost of mortgage interest repayments. Policy-‐makers raise interest rates to tackle inflation, but the increased interest rates increases mortgage interest repayments. This makes inflation look worse, which makes policy-‐makers look incompetent.
Costs of Inflation
Menu Lists-‐ firms have to keep changing price lists due to changing prices
Time Consuming-‐ fluctuating prices means that consumers need to spend time researching to work out what a good price is at any given time. Also, inflation increases the opportunity cost of holding onto money, so people have to make more visits to banks.
Distortion of Price Mechanism-‐ when prices keep changing, consumers and producers tend to have insufficient information on the general price level, so it is difficult for them to make informed decisions. This leads to an inefficient allocation of resources.
Business Planning-‐ high and volatile inflation makes long-‐term planning even more difficult.
Fixed Incomes-‐ consumers on fixed incomes (e.g. pensioners) lose out because the money they receive is worth less.
Global Competitiveness-‐ if the exchange rate stays the same, the increase in prices will put off foreigners, so exports will fall. Similarly, residents look to imports as cheaper alternatives than buying within the economy. This fall in exports and rise in imports leads to a fall in AD and a fall in employment.
Wage Price Spiral-‐ in response to a rise in prices, workers demand higher wages due to the higher cost of living. This increases firms’ costs and, in an effort to maintain their profit margins, they increase prices. This effect can repeat over and over, and inflation can easily get out of control.
Why do we not aim for 0% inflation?
- A 0% inflation rate is very difficult to achieve.
- Inflation reduces the cost of borrowing, both for firms and households, and this will increase investment.
- There are benefits of a low level of inflation (e.g. allows firms to reduce their costs by not rising wages in line with inflation. This might mean that they can reduce the number of workers they make redundant)
- The inflation rate is normally overstated due to the ‘substitute effect’ (see above), so a 0% rate will in fact be a negative value (deflation)
Practice: Inflation Data
Describe what the graph tells us about inflation in the UK between 2007 and 2009.
| Year | Output | Price | Nominal | Real |
|---|---|---|---|---|
| 1 | 5 | 2 | 5 x 2 = 10 | 5 x 5 = 25 |
| 2 | 5 | 5* | 5 x 5 = 25 | 5 x 5 = 25 |
| 3 | b | 10 | 8 x 10 = 80 | 8 x 5 = 40 |
- There is never any deflation (a fall in prices) because the rate never falls below 0%.
- The inflation rate falls by 1% (CPI) between March 2007 and September 2007. This means that the prices are still rising, but are rising at a slower rate (disinflation)
- The inflation rate reaches a peak of 5% in September 2008.
Inflation is the sustained increase in the general price level of goods and services in an economy over a period of time. It reduces the purchasing power of money, as it takes more money to buy the same amount of goods and services.
There are several causes of inflation, including increases in the money supply, higher production costs, and excess demand for goods and services.
Inflation can have both positive and negative effects on the economy. Some of the negative effects include a decrease in the value of money, reduced investment and economic growth, and increased uncertainty. Some of the positive effects include an increase in demand for goods and services, increased employment opportunities, and an increase in economic output.
Inflation is usually measured by tracking changes in the consumer price index (CPI), which measures the price changes of a basket of goods and services that are commonly purchased by households.
There are several types of inflation, including demand-pull inflation, cost-push inflation, and built-in inflation. Demand-pull inflation occurs when demand for goods and services exceeds the supply, leading to an increase in prices. Cost-push inflation occurs when production costs increase, leading to higher prices. Built-in inflation occurs when workers and businesses expect prices to rise, and they build this expectation into their wage and price-setting decisions.
Deflation is the opposite of inflation, and it refers to a sustained decrease in the general price level of goods and services in an economy over a period of time.
There are several strategies to control inflation, including monetary policy, fiscal policy, and supply-side policies. Central banks can use monetary policy tools such as adjusting interest rates and open market operations to control the money supply and influence inflation. Governments can use fiscal policy tools such as taxation and government spending to influence aggregate demand and inflation. Supply-side policies such as deregulation and investment in technology and infrastructure can increase productivity and reduce production costs, which can help control inflation.
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