Inflation
These Edexcel A-Level Economics revision notes cover unit 2.1.2, explaining how inflation is measured using the CPI and RPI, the key causes of demand-pull and cost-push inflation, and how rising price levels affect different economic agents.
Definitions: Inflation, Deflation, Disinflation
Inflation: A sustained increase in the general or average price level of goods and services in an economy.
Deflation: A sustained decrease in the general price level, giving a negative inflation rate.
Disinflation: A decrease in the rate of inflation. Prices are still rising, but at a slower pace.
Measuring Inflation: The Consumer Price Index (CPI)
- CPI is the UK's official measure. The Bank of England has an inflation target of CPI 2%.
How It's Calculated
Basket of Goods: A representative basket of around 700 goods and services that an average household buys is created and updated annually.
Weighting: Items are weighted according to their proportion of household spending. For example, energy (heating, electricity, gas) has a greater weight than clothing.
Price Collection: Prices are collected monthly from numerous locations.
Index Calculation:
\[ \text{CPI} = \frac{\text{Price of basket in current year}} {\text{Price of basket in base year}} \times 100 \]
\[ \text{Inflation Rate} = \frac{\text{CPI Year2 - CPI Year1}} {\text{CPI Year1}} \times 100 \]
Limitations of the CPI
Not Representative: The average basket may not reflect the spending patterns of different households, such as pensioners and students.
Regional Variations: CPI ignores differences in price changes across the country.
Quality Changes: It does not fully account for improvements in product quality over time.
Substitution Bias: It can be slow to reflect when consumers switch to cheaper alternatives.
Data Collection Errors: It is based on a sample survey, which can be inaccurate.
Retail Price Index (RPI)
- RPI is an alternative measure that includes housing costs, such as mortgage interest and council tax.
- It generally yields a higher inflation rate than CPI.
- It is considered less reliable for international comparisons and is not the UK's official target measure.
Causes of Inflation
Demand-Pull Inflation
Demand-pull inflation: occurs when there is an increase in aggregate demand (AD) that exceeds the economy's productive capacity, leading to upward pressure on prices.
Causes: Higher consumer confidence, higher government spending, lower taxes, lower interest rates, and stronger export demand.
Cost-Push Inflation
Cost-push inflation: Occurs when there is rise in the costs of production for firms, shiftting the SRAS curve leftwards.
Causes: Higher global commodity prices, higher wages, higher business taxes, supply chain shocks, and a depreciation of the currency which increases import costs.
Growth of the Money Supply
Excessive growth in the money supply, such as through quantitative easing, can fuel demand-pull inflation and cost-push inflation.
- A large increase in the money supply can lead to higher consumer spending and demand-pull inflation as it results in lower interest rates at commercial banks and increased borrowing.
- An increase in the money supply can lead to higher production costs and cost-push inflation. For example, it can lead to a depreciation of the currency, which increases the cost of imported raw materials and components for firms.
- An increase in the money supply can lead to higher asset prices, which can increase the cost of capital for firms and lead to cost-push inflation.
Wage-Price Spiral
A vicious cycle where rising prices in the economy lead to higher wage demands from workers, which in turn increases firms' costs and leads to further price increases. This can sustain inflation even if the initial cause has been resolved.
Effects of Inflation
| Stakeholder | Potential Negative Effects |
|---|---|
| Consumers | Decreases the real incomes of consumers, especially if wages do not keep up with inflation, leading to a fall in living standards. It also erodes the value of savings, as the real value of money saved decreases over time. |
| Firms | Uncertainty discourages investment, higher inflation than trading partners erodes international competitiveness, and firms face menu costs from changing prices. |
| Government | The government may need to increase state pension and benefit payments, and higher inflation can create political dissatisfaction. |
| Workers | Real wages fall if nominal wage rises are below inflation, which can lead to industrial disputes. |
| Economy | Inflation can cause balance of payments problems and distort price signals, leading to a misallocation of resources. |
Exam Preparation
- Define and distinguish between inflation, deflation, and disinflation.
- Explain how the CPI is calculated and evaluate its limitations.
- Draw and analyse AD/AS diagrams to illustrate demand-pull and cost-push inflation.
- Analyse the impact of inflation on different stakeholders, including consumers, firms, government, and workers.
- Evaluate the severity of inflation, for example whether it is high or low, and anticipated or unanticipated.