3. Inflation

the macroeconomic policy objective of low and stable inflation

2% measured with CPI. this aims to provide price stability for firms and consumers and will help them make decisions for the long run. If the inflation rate falls 1% outside this target the governor of the Bank of England has to write a letter to the Chancellor for the Exchequer explain why this happened and what the bank intends to do about it

Key points when answering an exam question on the CPI

A survey is used, weighted basket of goods, measures average price change of the goods, updated annually

consequences of inflation on the government

Government will have to increase the value of the state pension and welfare payments, because the cost of living is increasing.

consequences of inflation on firms

Low interest rate's mean borrowing and investing more attractive than saving profits. With high inflation, interest rates are likely to be higher so cost of investing will be higher and firms less likely to invest. Workers might demand higher wages which increases costs. Firms may be less price competitive on a global scale if inflation is high, depends on what happens in other countries though. Unpredictable inflation reduce business confidence, less investment.

consequences of inflation on workers

Real incomes fall with inflation, so workers have less disposable income. If firms face higher costs could be more redundancies when trying to cut costs

triggers for demand pull inflation

a depreciation in the exchange rate which causes imports to become more expensive whilst export become cheaper causing AD to rise. fiscal stimulus in the form of lower taxes/more government spending, meaning more disposable income for consumers so spending increases. lower interest rates makes saving less attractive and borrowing more tractive so consumer spending increases. High growth in UK export markets means UK exports increase and AD increases

causes of deflation

a fall in aggregate demand: deflation usually caused in recessions, when output and demand are decreasing. If the supply of money falls in the colony, could be fall in average price level caused by tightening of monetary policy, such as with higher interest rates. increasing aggregate supply: lovers but action costs for firms, output increases at the same time, this type of deflation not normally considered as bad as if it is caused by falling AD

retail price index RPI

alternative measure of inflation. Unlike CPI, RPI includes housing costs, such as payments on mortgage interest and council tax. Some consumers think this more accurately reflects the cost of living. RPI tends to have a higher value than CPI due to the inclusion of housing costs. RPI has been used for much longer than CPI, which makes it better for comparisons overtime. RPI unique to UK, not consistent with European Central bank's inflation measurement like the CPI is. Therefore, CPI more accurate for making comparisons between European countries.

limitations of cpi when measuring inflation

basket of goods only representative of average household, different demographics have different spending patterns, housing costs account for about 16% of the index, yet this varies between people. CPI is slow to respond to new goods and services even though it is updated regularly.

deflation

deflation is the upset of inflation, what average price level in the economy falls. There is a negative inflation rate.

causes of inflation

demand pull cost push growth of money supply quantitative easing

disinflation

disinflation is the falling rate of inflation. This is when the average price level is still rising, but too slow extent. This means goods and services are relatively cheaper now than a year ago, the purchasing power of money has increased.

calculating the inflation rate in the UK

done using consumer prices index bracket CP I bracket. It measures household purchasing power with the family expenditure survey. The survey finds out what consumer spending come on. From this, a basket of goods is created. The goods are weighted according to how much income is spent on each item. E.g. petrol has a higher weighting than tea. Each year, the basket updated to account for changes in spending patterns.

cost push

from the supply side of the economy and occurs when a firm's face rising costs

quantitative easing

has been used by the European Central bank to help stimulate the economy. Since interest rates are already very low it is not possible to lower the much more. This means the bank To adopt another measure: pumping money directly into the economy. The bank bought assets in the form of government bonds are using the money they have created. This is then used to buy bonds from investors, which increases the amount of cash flowing in the financial system. this encourages more lending to firms and individuals. The theory is that this encourages more investment, more spending, and hopefully higher growth. A possible effect of this is that there could be higher inflation.

hyperinflation

hyperinflation is when the rate of inflation is high and exhilarating, to the extent that it is out of control.

growth of the money supply

if bank of England printed more money there would be more money flowing in the economy, extreme increases in the money supply usually cause hyperinflation, when the rate of inflation is incredibly high and uncontrollable. It is only inflationary if the money supply increases at a faster rate than real output.

calculating the rate of inflation using index numbers

index numbers are used to make comparisons between years, and to measure the magnitude of change over time. A base year is used and then compared to other years. In the calculation of CPI, different items in the basket of goods have different weights. food will have a much larger waiting on clothing, since consumers spend more of their income on food. The index number measures the change in price over time.

inflation

inflation is the sustained rise in the general price level over time. this means that the cost of living increases and the purchasing power of money decreases

cost push inflation occurs when

raw materials become more expensive. Labour becomes more expensive, this could be through trade union is. Expectations of inflation, if consumers expect prices to rise they may ask for higher wages to make up for this and could trigger more inflation. Indirect taxes could increase the cost of goods if producers pass the cost onto the consumer. Depreciation in the exchange rate causing imports to become more expensive which pushes up the price of all materials. Monopolies using the dominant market position to exploit consumers with high prices

demand pull

this is from the demand side of the economy. When I got demand is growing unsustainably, there is pressure on resources. Producers increase their prices and earn more profits. Usually occurs when resources are fully employed.

consequences of inflation on consumers

those on low and fixed incomes are hit hardest by inflation and do you to its regressive effect, because the cost of necessities such as food and water become expensive. if consumers have lines, the value of the repayment will be lower because the amount owed does not increase with inflation, so the real value of debt decreases.

consequences of deflation

value of money increases. sharp decline in consumer spending. Declining consumer spending is particularly obvious in expensive items. Economy might crash and the unemployment rate might increase, adding more deflationary pressure to the price level. debt burden on consumers increases in real terms. since interest rates could not be negative, writer and deflation is below interest rate, means by saving money the real value of the savings increases, furthers the possibility of low growth. nominal wages "sticky" which means workers resist pay cuts means real wages rise when there is deflation causing unemployment.