2.1.2 Inflation
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, housing has a greater weight than clothing.
Price Collection: Prices are collected monthly from numerous locations.
Index Calculation:
\[ \text{CPI} = \frac{\text{Price of basket in current year}}{\text{Price of basket in base year}} \times 100 \]
\[ \text{Inflation Rate} = \frac{\text{CPI Year 2 - CPI Year 1}}{\text{CPI Year 1}} \times 100 \]
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
Cause: Aggregate Demand rises faster than Aggregate Supply. This is often described as too much money chasing too few goods.
Triggers: Higher consumer confidence, higher government spending, lower taxes, lower interest rates, and stronger export demand.
Cost-Push Inflation
Cause: A rise in the costs of production for firms shifts the AS curve leftwards.
Triggers: Higher global commodity prices, higher wages, higher business taxes, and supply chain shocks.
Growth of the Money Supply
Link: Excessive growth in the money supply, such as through quantitative easing, can fuel demand-pull inflation.
Wage-Price Spiral
A vicious cycle where rising prices lead to higher wage demands, which increase firms' costs and lead to further price rises. This combines demand-pull and cost-push inflation.
Effects of Inflation
| Stakeholder | Potential Negative Effects |
|---|---|
| Consumers | Lower purchasing power of income, lower real value of savings, menu costs, and uncertainty. |
| 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.