inflation

differences between cpi and rpi

- cpi excludes a number of items rpi includes mainly relating to housing costs. these include: council tax, mortgage interest payments, house depreciation and housing fees therefore in times of housing boom the cpi will be lower than the rpi as housing costs rise at a faster rate than other items. however, with very low interest rates, mortage repayments and housing costs the rpi figures were much lower than cpi figure, e.g. in 2009 the cpi is a geometric mean and rpi is arithmetic, this makes cpi generally lower than rpi due to statistical difference rpi excludes high income households - top 4% and pensioners who derive at least 75% of their income from the state where as the cpi includes all households

benefits of low inflation

2% low inflation positive increase in prices isnt deflation but not significant rate of inflation avoids problems of high inflation and deflation gives policy makers like central banks and gov room to adjust economy if inflation goes higher or lower inflation at 0.5, signal that rate of growth of ad needs to increase lest price growth becomes negative if inflation is 4 per cent, ad needs to decrease in growth lest inflation increases affect on asset prices at 2 per cent the real value of borrowing falls gradually over time this makes it easier for those who borrow to finance consumption or investment to repay their borrowings. it also doesn't impact much on incentive to save as savers dont take real erosion of their savings into account, they suffer from money illusion, thinking inflation is 0

weighting

changes in price of food are more important than changes in price of tobacco, because larger proportion of total household income is spent on food than tobacco, therefore figures must be weighted before final index is calculated

inflation better than deflation

even though inflation leads workers to bargaining higher wages, increasing wage spiral, inflation better than deflation if prices are falling then consumers will put off purchases, as will businesses, reducing ad and price levels further, less consumption and investment, deflationary spiral allows real wages too fall as workers are more willing to accept them than nominal wage cuts, help labour market clear and aid employment

benefits of inflation: effect on growth and unemployment

high inflation is unpredictable, unanticipated inflation makes it difficult for consumers and firms to plan, less likely to take risks. consumers may bring forward or reduce purchasing depending on what they think, this disrupts patterns of spending, difficult for firms to supply goods economic disruption means lower levels of output and spending, lower growth, higher unemployment low and stable inflation creates a stable environment for investment, benefiting economic growth of economy . higher inflation discourages investment, any boost to investment increases ad and as, therefore increasing economic growth trade off between inflation and unemployment in short run shown by phillips curve. higher inflation - low and high levels of unemployment. high demandside inflation means economy is operating towards full employment

competitiveness

higher inflation in uk compared to other countries, and value of pound doesn't change on foreign currency markets, then exports will be less competitive and imports more competitive, loss of jobs in domestic economy and lower growth. adverse effect on current account balance of payments - this assumes exchange rate does not change, does not take into account quality of exports and imports

shoe-leather costs

if prices are stable, consumers and firms come to have knowledge of what is a fair price for a product and which suppliers are likely to charge less than others. at times of rising price, consumers and firms will be less clear about what is a reasonable price. this will lead to shopping around, wearing out shoes, which is a cost. high rates of inflation lead to households and firms holding less cash and more interest bearing deposits. inflation erodes value of cash but since nominal interest rates are higher than with stable prices, opportunity cost of holding cash is larger, with higher inflation. households and firms are forced to spend more time transferring money from one type of account to another or putting cash into account to maximise interest paid, this time is a cost individuals want to hold less cash as it loses value quicker with inflation, instead use interest bearing accounts. therefore more time will be spent shopping around for best accounts, increases costs overall price signalling function of the price mechanism is less effective, however the increase i price comparison sites could reduce the shoe leather costs associated with inflation and increase inf consumers have

menu costs

if there is inflation, restaurants have to change their menus to show increased prices. shops have to change price labels and firms have to issue and calculate new price lists. even more costly are changes to fixed capital, such as vending machines and parking meters, to take account of price increases some of these costs can be reduced if inflation can be predicted, anticipated inflation allows economic actors to plan for future and adjust decision making to take inflation into account. one way of doing this is through indexation. this is where economic variables like wages or taxes are increased in line with inflation. e.g. a union might negotiate a wage agreement with an employer for staged increases over a year of 2 per cent plus the change in rpi. the annual changes in social security benefits in the uk are linked to the rpi. indexation reduces some of costs of inflation but menu costs and show leather prices remian it reduces pressure on gov to tackle this problem of inflation directly, eases pain but doesn't cure it indexation may hinder gov attempts to reduce inflation because indexation builds in further cost increases, such as wage increases, which reflect past changes in prices - if inflation 10 and gov wants it to be 2, increasing wage due to indexation will not do anything

re distributional costs

inflation can redistribute income and wealth between households, firms and the state anyone on fixed income will suffer. in uk, pensioners on fixed pensions from private company pension schemes not adjusted for inflation. if prices double, real income will halve. any group of workers which fails to negotiate pay increases in line with inflation will suffer falls in income if real interest rates are negative due to inflation, there will be a transfer of resources from lenders to borrowers. with interest rates at 10% and inflation rates at 20%, savers will lose 10 percent of real value of savings each year while borrower will see 10 percent reduction in value of debt per accum taxes and government spending may not change in line with inflation. if chancellor fails to increase excise duties on alcohol and tobacco each year inline with inflation, real gov revenue will fall whilst drinkers and smokers are better off in real terms assuming their incomes have risen at least by as much as inflation if chancellor fails to increase personal income tax allowances, the amount a worker can earn tax free, in line with inflation, then the burden of tax will increase, transferring resources from the taxpayer to the government

inflation, disinflation and inflation

inflation is defined as a sustained general rise in prices across economy. the opposite of inflation is deflation. this is a sustained general fall in prices across economy. disinflation is fall in rate of inflation. if prices in general are rising by 3% per annum, there is inflation. if prices in general are falling by 1% there is deflation. if rate of inflation falls from 4% to 2%, there is disinflation. if there id disinflation, prices are still rising, still inflation, just rate of inflation is falling

hyperinflation

inflation levels are very high 50% or more annual inflation

stagflation

inflation rising or is very high at time when economy is in recession economy stagnating, but there is inflation

good deflation and bad deflation

japan has problems of deflation. consumers may decide to postpone purchases as they will be cheaper in future time period. this causes consumption and ad to fall, meaning further fall in PL. deflation hurts savers who see fall in real value of their savings fall, whereas it benefits borrowers, real value of debt fall good deflation when AS, e.g. due to lower oil prices or higher productivity, increases, this should be good for economy as there is growth and more internationally competitive export sector. bad deflation occurs when aggregate demand is falling e.g. due to lower consumer and business confidence, falling growth and rising unemployment

deflation

lower prices consumer confidence low if they don't buy today, can buy cheaper tomorrow lack of business confidence lower investment interest rates low with deflation real cost of borrowing higher prices fall by 1 per cent, then the real cost of borrowing is the actual or nominal interest rate plus 1 per cent savers see the real value of their savings increase even if they only receive one or 2 per cent interest if prices fall by 2 per cent and they receive 1 per cent interest, then real rate of returns on their savings is 3 pr cent incentive to save - low or negative economic growth borrowers - deflation leads to real value of debt increasing

cpi

more recent measure of price level, having been officially calculated from 1996. it is the eu measure and therefore allows comparisons to be made between eu countries. this is the main reason bank of england uses it as main measure of inflation, targeting cpi at 2%, however the rpi will still continue to be calculated

limitations of using only an average rate of inflation

only an average rate of inflation: inflation is only an average figure, personal rate of inflation may be higher or lower than this. those on low income e.g. pensioners spend more on necessities like food/heating, therefore if price of food rises these people are hit harder than average figure suggests, they would be less hit by rises in luxury items the weightings are fixed each year: the fact that weightings are only updated every year means they may not be accurate during the year. for example, if consumers switch away from very expensive product during the year this isn't taken into account . therefore cpi cannot reflect these substitution effects that occur before the weights are changed the weightings change over time: this means the basket of goods being compared this year is different to previous years, which affects ability to affect prices over time - spending on food 30 yrs ago was higher proportion of spending the index cannot indicate changes in quality of goods, only the price: the price of cars may have risen due to them being of higher specification rather than due to an inflationary price rise sampling issues: quality of inflation measure depends on number of people surveyed - typically just over half respond - and the accuracy of responses cpi does not include housing costs: these costs may be a substantial part of some consumers' costs of living. when these housing costs change dramatically, rpi may be better measure. new version of cpi called cpih

deflationary policies

policies pursued by governments designed to reduce rate of economic growth, if successful, they will almost certainly reduce rate of inflation never aimed to bring about negative inflation - not linked to deflation

psychological and political costs

price increases are deeply unpopular people feel they are worse off, even if their income rise by more than rate of inflation high rates of inflation, unexpected, disturb the distribution of income and wealth , affect existing social order change and revolution in past have accompanied periods of high inflation

calculating a price index

prices of a representative range of goods and services, a basket of goods, need to be recorded on a regular basis in the uk, basket is calculated from the results of the living costs and foods survey each year, a few thousand households are asked to record their expenditure for one month from these figures, it is possible to calculate how the average household spends its money - average household only exists as statistical entity e.g. household spends 4 pound on men's trousers a week with this info, surveyors are sent out each month to record prices for the mix of goods and services that the living costs and food survey has shown is bought by UK households prices are recorded in different areas of the country as well as in different types of retail outlets, like corner shops and supermarkets - results averaged out to find the average price of goods, this figure converted into index number form

reflation

rise in gdp which occurs following a recession

example

there are only 2 goods in economy - food and cars household spends 75% of income on food and 25% on cars increase in price of food by 8% and increase in price of cars by 4% in one year a normal average would add together 4 and 8 and divide by 2, increase of 6% however this is inaccurate, spending on food is more important than spending on cars for household budget figures must be weighted food given weight of 0.75, cars given weight of 0.25 average increase in prices is 8 times 0.75 added to 4% times times 0.25, 6 plus 1 the weighted average is 7%. if cpi were 100 at start of year, it would be 107 by end of year

RPI

traditional measure of the price level and is used to index state pensions and benefits, is used by trade unions to negotiate wages and by utility regulators to set prices rpi is the headline rate of inflation rpix: which is the rpi excluding mortgage repayments. this is done so policymakers can see changes in the price level without including volatile and distorting elements of the rpi, especially when house prices are rising rpiy: which is the rpi excluding mortgage repayments and indirect taxation. this again allows policymakers to see how prices are changing in the wider economy rpix and rpiy are called underlying measures of inflation. the bank of england previously used to target rpix at a rate of 2.5

measuring inflation

uses index. if price levels were 100 today and 110 next year, rate of inflation would be 10% in UK there are two widely used measures of price level, retail prices index and consumer prices index