Inflation and Deflation

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Inflation is the sustained rise in the average price of goods and services over a period of time - not all goods rise the same

Inflation is the fall in the value of money. This means money buys less than it would before and purchasing power has fallen

Deflation is the sustained fall in the average price of good and services over a period of time

Hyperinflation is when prices rise extremely quickly and money rapidly loses its value

Disinflation is when rate of inflation is slowing down- prices rising slower

Measurements of Inflation

Retail Price Index:

Two surveys carried out to calculate RPI

1) Living Costs and Food survey- survey of around 6000 household to find out what people spend their money on. This survey used to find out relative weighting of each item

2) Based on prices measures changes in price of around 700 of most commonly used goods and services. The goods are based on living costs and food survey.

Price changes from second survey multiplied by weightings from first survey- then converted into index number

CPI- similar calculation to RPI

Excludes mortgage interest payments and council tax

Slightly different formula to calculate the CPI

Larger sample of the population used for CPI

CPI tends to be lower than RPI figures

CPI is official measure of inflation in the UK- very good for international comparison

Limitations of CPI and RPI

RPI excludes all top 4% of incomes.

Although CPI covers a broader range, it doesn't include mortgage interest payments or council tax

Information given by households in Living costs and food Survey can be inaccurate

Basket of goods changes just once a year- miss out short term change in spending habits

Important for Government policy decision

Used to decide wages and state benefits

- Employers use them for a start in wage negotiations

-Government use them to decide on state pensions

- Benefits given are sometimes index linked

International competitiveness

If CPI measured rate of inflation is higher in UK than with countries it trades with, UK goods become less price competitive- cost more for other countries to buy

Exports will fall, imports will increase - increasing the current account deficit

What causes inflation?

Inflation can be caused by Cost-Push factors:

Cost Push inflation is inflation caused by rising costs of inputs to production

The rising costs of inputs to production mean producers have to pass on the higher costs to consumers in the form of higher prices. This causes AS to shift to the left

This is caused by:

Rise in wages above any increase in productivity

- If wages make up large percentage of firms total costs, lead to significant rise in price

- Prices could rise to further wage demands- create wage-price spiral - increase the price of products

Rise in cost of imported raw materials

- If world prices of inputs rise in the short run producers will pay higher costs and then set higher prices

- If countries value of currency decreases then producers will have to pay for imports

Rise in indirect taxes

- Government rises indirect taxes, increase costs and this will increase prices

- If a good is price inelastic, more of the tax will be passed on to the consumer

Inflation can be caused by Demand-Pull Factors:

Demand Pull Inflation is inflation which is caused by excessive growth in AD compared to supply

Growth in demand shifts AD curve to right allowing sellers to raise prices

This could be caused by:

High Consumer spending

- High Consumer Spending could be caused by high levels of confidence in future employment prospects. If there is a monetary policy of low interest rates it will encourage borrowing and spending

High Demand for Exports

- High foreign demand for exports could be caused by rapid economic growth in other countries

Money supply growing faster than output

- If amount of money in economy isn't matched to the amount of goods and services- say theres too much money chasing too few good- leads to a rise in prices.

- Monetarist economists believe excess money is biggest cause of inflation

Bottleneck shortages

- If demand grows quickly at at time when labour and resources are already being fully use then increasing output will lead to shortages. This will cause prices to rise and firms costs to increase

-price rises caused by shortages in one area of the market may be copied by other markets

Quantity theory of money based on Fishers equation of exchange

Money supply x velocity = price level x aggregate transactions

MV= PT

Monetary economists argue that in the short run V & T are unlikely to change

Any increase in P will be directly by an increase in M

Both sides of equation assumed equal

Any increase in money supply will create same percentage increase in price level

In order to avoid inflation, monetarists believe money supply need to be controlled strictly

Consequences of Inflation

Cause those on fixed/ near fixed incomes standard of living to fall biggest impact on those in low income employment or welfare benefit

Country's competitiveness will be reduced by inflation as exports cost more to buy and imports cheaper- cause unemployment s less domestic demand

Discourages savings as value of savings fall. Makes more attractive to spend

Reluctance to save creates shortages of funds for borrowing and investment- hard for firms to make improvements

Creates uncertainty for firms as rising costs will reduce investment

Can cause shoe leather costs- costs of extra time and effort by consumers to search for up to date price information on goods and services using as well as menu costs which is the price of altering information for producers

Hyper inflation is a possibility where inflation grows very quickly to very high levels

Policies to deal with inflation:

-Fiscal Policy- increase income tax for demand pull inflation

Deflation is a persistent fall in general price level of goods and services.

Deflation occurs when rate of inflation falls below 0%

Deflation occurs when asset prices and consumer prices continue to fall

Causes of Deflation

Demand Side Causes of Deflation

- Deep fall in AD - persistent recession

- Large negative output gap- a lot of spare capacity

Supply side Causes of Deflation

-Improved productivity

-Technological advances

-Significant fall in wage rates

- High Exchange rates causing import prices to fall

Damaging effects of deflation

Consumers hold back on spending

Debts increase-real value of debt increases

real cost of borrowing increases

lower profit margins for firms- causes higher unemployment

Fall in confidence - Falling asset prices such as deflation in housing market

Income Distribution- redistribution from debtors to creditors

Make exporters more competitive eventually- higher unemployment in the short term

Ways to Fix

Monetary Policy

Low interest rates

Quantitive easing to expand supply of credit

Fiscal Policy

Higher Government Spending

Rise in Government Borrowing to Inject demand

Lower Direct taxes to increase disposable income

Demand caused deflation the worst

Followed by Cost Push Inflation

Followed by Demand Pull Inflation

Followed by Deflation caused by rising productivity