Define inflation. Define price level. Define deflation. Deflation. Define disinflation. The average price of goods and services in the economy

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1 Define inflation A general and sustained rise in prices ( measured by a change in weighted index of prices such as CPI) Define price level The average price of goods and services in the economy Define deflation A fall in the price level ( i.e inflation below 0% :negative) If inflation is below 0%, what is this called? Deflation Define disinflation A fall in the rate of inflation prices rising more slowly, but still rising

2 Define Consumer Price Index (CPI) A measure of the price level. Used across the EU and Bank of England to measure inflation against it's target of 2% Define Retail Prices Index (RPI) A measure of the price level which has been calculated in the UK for over 60 years and is used in a variety of contexts such as by the government to index welfare benefits Define inflation rate The percentage change in the Consumer Price Index (CPI). This is calculated relative to a base year, set equal to 100 A fall in the rate of inflation is known as disinflation means that the cost of living of the typical household is rising less quickly. It does not mean falling prices which is known as disinflation deflation

3 Why is inflation measured using an index, such as CPI? Because, using an index allows percentage changes to be shown easily, making effective comparisons over time possibile CPI measures not the level of inflation. However CPI refers to inflation, as measured using CPI price levelinflation What type of inflation measure does the UK government use? CPI inflation surveys are used to calculate inflation. These are:... 2 Living costs & food survey (LCF) Price survey The first survey is called the & survey. It involve the collection of information about... living costs & food (LCF)what people buy

4 Explain what is done within the Living Costs and Food Survey (LCF) ( the first survey used to calculate inflation) living costs & food (LCF)what people buy How is the living costs & food survey completed? 1. Asks 11,500 households chosen randomly to record what they spend over 2 weeks 2. Used to decide a 'basket': 650 goods & services (for which price info is collected in the next survey) 3. RPI and CPI are weighted to reflect importance of different expenditures in the basket Explain what weighting is, with regard to CPI and RPI In the Living Costs and food survey:weighting is used to understand the relative importance of each good or service in the basket - done using proportion of income spent on good e.g if 10% of income is spent on food, then 10% out of 100 weighting is assigned to food Roughly how many households are chosen to participate in the Living Costs and Food Survey? 11,500 Roughly, what percentage of households participate in the Living Costs and Food Survey? 50%

5 Which of the 2 surveys consists of determination of a basket? The Living Costs and Food Survey 650 How many representative goods and services are included in the 'virtual basket' How often is the first survey: living costs and food survey completes? every year How long are households asked to record their spending pattern for (within the living costs and food survey)? 2 weeks What is the second survey which is done to obtain inflation statistics? Price Survey

6 Explain what is done in the price survey Prices of the 650 goods are obtained: Prices are collected in 141 different areas of the UK (random sampling) and a range of shop types 100,000 prices are collected for the 650 goods in the 'basket' A further 80,000 prices are collected where local sampling is inappropriate (e.g internet, utility bills, mortgage interest payments) How often is the price survey completed? Monthly Why is the price survey completed over a range of outlets across the country? Because similar items can be bought in high and low cost shops. How many areas of the UK are sampled to obtain prices? 141 areas Roughly, how many prices are collected for the 650 basket goods (in total)? 180,000

7 Price changes which are obtained from the price survey are multiplied by the weights from the Living Costs and food survey to give... A price index Why are there 2 surveys for the CPI? The expenditure survey shows us the proportion of income spent on each item, so that we can weight the price changes in terms of importance to consumers. The price survey tells us the change in prices for each good and service weight * change in price = index Reasons why the 'basket' of 650 goods is updated yearly? New technology Food no longer eaten e.g rabbit Social trends e.g convenience foods Reasons why the basket of 650 goods is updated yearly? New technology Food no longer popular e.g rabbit Social trends e.g convenience foods data is used to calculate average price rises for each of the 650 goods/services in the basket Price survey

8 A greater is given to goods/services which account for a greater proportion of income weight E.g food contributes to 75% of overall spending. It is given a weight of 750 out of The price survey reveals that food prices increase by 8%. How much would this increase in food price contribute to the increase in CPI price level? 8% 0.75 = = 6% E.g cars contributes to 25% of overall spending. It is given a weight of 250 out of The price survey reveals that car prices increase by 4%. How much would this increase in car prices contribute to the increase in CPI price level? 4% 0.25 = = 1% Outline the main differences between RPI and CPI International comparisons: CPI used in all EU countries Calculation Method: RPI: Arithmetic mean for prices > CPI: Geometric mean for prices Housing Costs: CPI excludes items related to housing e.g mortgage interest rates Population Covered: CPI covers all households, RPI excludes extreme 4% Explain how RPI and CPI are different, with regard to international comparisons CPI is used in all EU countries: good for comparisons RPI is a traditional UK measure as it uses a unique statistical method of basing the data

9 Explain how RPI and CPI are different, with regard to calculation methods RPI uses an arithmetic mean: prices are added and divided by the number of items CPI uses a geometric mean: Calculated by multiplying prices of items together, and taking nth root of them, where n is the number of items The RPI uses an arithmetic mean, whilst the GPI uses a geometric mean. This tends to cause RPI to be than the CPI higher Explain how RPI and CPI are different, with regard to housing costs CPI excludes some items related to housing, which are included in the RPI e.g mortgage interest rate Which measure of inflation is more inclusive, and includes things such as mortgage interest payments and council tax RPI is more inclusive RPI includes housing factors. The extreme fall in house prices at this time means that RPI is much lower What is the main reason as to why RPI fell much lower than CPI in 2009?

10 Explain how RPI and CPI are different, with regard to population covered CPI is more inclusive as it covers all households RPI excludes top and bottom 4% of income earners on the basis that they are not typical Why does the government like to exclude housing costs in the main measure of inflation? List the issues with CPI as a measurement of the rate of inflation Housing costs are not included in the CPI measure, used by many other countries. Housing costs included mortgage interest rates, which usually change when interest rates, so raising interest rates (in an attempt to reduce inflation) will in short term, make rate of inflation higher if housing costs are included. CPI measures cost of living for average household only Bottom and top 4% incomes excluded Sampling issues: only 57% respond List of 650 items only changed once/year CPI unrepresentative of atypical people Does not include housing costs, which form large part of spending Does not consider price rises due to quality improvements New products invented: inaccuracy of basket as the basket has changed so much How is inflation measured? [clue: Many students wast a lot of time by saying what inflation is. instead start with the two surveys and remember to refer to weights in your answer] The focus of the answer should be on the two types of survey involved.a weighted basket of goods, a price, survey, and index and a base year should form part of the answer What are the two Cost-push inflation

11 types of inflation? Demand-pull inflation

12 Define cost-push inflation Inflation ( a general increase in the general level of prices) caused by increases in the costs of production in the economy e.g rise in wages or fall in exchange rate which makes imports expensive Define demand-pull inflation Inflation ( a general increase in level of prices) which is caused by excess (aggregate) demand in the economy e.g increased consumption, investment, gov. spending or net exports - inflation is caused by excess demand i.e where AD>AS Demand pull Demand pull inflation often occurs when the economy is close to full capacity, Why? Because AS is inelastic at full capacity, meaning that AS is unresponsive to price changes, so cannot increase in response to changes in demand. Hence increasing the chance that there is excess demand Demand pull inflation can be where there is a output gap i.e... positive Current AD is higher than Potential Output

13 Demand-pull inflation A right shift of AD, without a change in AS can lead to (which type of inflation)? Why is demand-pull inflation often associated with multiplier effects? A right shift in AD i.e rise in consumption often leads to increased wages increased wages increased consumption firms respond by increasing prices to remove excess demand prices are increased further& positive wealth effect Cost-push inflation What type of inflation is caused by a left shift of AS? Short term examples of why cost push inflation occurs Increase in oil prices Changes to exchange rates which make imports more expensive Long term examples of why cost push inflation occurs Increased corporation tax Wage increases (e.g minimum wage or Trade Unions) Loss of factors of production i.e destruction of factories in natural disaster

14 Illustrate demand-pull inflation on an AS AD diagram Illustrate cost-push inflation on an AS AD diagram Increases in production costs cause AS to shift left, leading to... cost-push inflation Inflation can be controlled by changing money supply in order to change purchasing power of money i.e printing more/less money List some internal causes (inside the country) of inflation Surge in property prices (wealth effect=increased consumption: Demand-pull) Higher wages/labour costs (Costpush) Boom in credit/money supply (demand-pull) Rise in business taxes (cost-push)

15 List some external causes (inside the country) of inflation Increase in world oil/gas prices Global inflation in commodity prices Depreciation of exchange rate (making imports more expensive) Higher inflation in other countries Define anticipated inflation increases in prices which economic actors are able to predict with accuracy Define unanticipated inflation Increases in prices which economic actors, like consumers and firms fail to accurately predict, so their decisions are based upon poor information Define hyperinflation Large increases in the price level Define indexation Adjusting the value of economic variables such as wages or the rate of interest in line with inflation

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17 In 2012, price levels (CPI) rose by 2.8% and then 2.6% in How might a pensioner on a fixed income be affected in real terms? Purchasing power of their income falls as prices are rising, but their income is constant In 2012, price levels (CPI) rose by 2.8% and then 2.6% in How might a bank deposit saver on a fixed interest rate of 0.5% be affected in real terms? The real value of savings falls because the rate of interest is constant, and does not increase in-line with inflation. In 2012, price levels (CPI) rose by 2.8% and then 2.6% in How might a worker whose income increased by 16.5% be affected in real terms? he/she is better off, because their income increased by a greater amount than the inflation. They essentially are facing a 13.87% income rise In 2012, price levels (CPI) rose by 2.8% and then 2.6% in How might a single mother with 1 child on a fixed child benefit be affected in real terms? The quality of life for the mother and child fall because her income does not increase in line with inflation. The purchasing power of this fixed income falls due to inflation. In other words, the real value of the benefits has fallen Disadvantages of inflation to consumers Savings & assets (real value) fall if inflation rate is above interest rate Purchasing power falls: -ve impact on fixed incomes Shoe leather costs: costs of shopping around due to fluctuations and lack of info of market prices Unemployment rises because firms face higher costs (particularly cost-push) + AD likely to fall because fixed incomes afford less

18 Advantages of inflation to consumers Disadvantages of inflation to firms Advanatages of inflation to firms Those with high levels of personal debt benefit from inflation as the real value of the debt falls in the same way real value of savings is eroded Does not affect those on indexed incomes (i.e adjusted for inflation) If firms are slow to respond and don't increase their prices, consumers will be better off because their wage may increase, but prices don't Loss of international competitiveness exports expensive, imports cheap Increased Uncertainty: reduce investment due to unpredictability and falling consumption Costs of adjusting menus Less investment from abroad if inflation why buy into a currency that is falling in real value Firms may use inflation to erode the value of their worker wages without cutting them in nominal terms people more likely to accept real wage fall rather than nominal Consumption may rise: less reason to save if inflation Disadvantages of inflation to Government Advantages of inflation to Tax revenue falls if taxes not increased in-line with inflation Trade deficit worsens because more imports cheaper, and exports expensive for foreign customers Budget deficit worsens because unemployment benefits or indexed incomes Cost of menu changing Political instability (e.g Nazi Germany) Redistribution of income: those on fixed incomes: fall in disposable Y, but indexed do not lose out Reduced real interest rate, erodes national debt value

19 Government Can cut public sector wages and benefit payouts by freezing them real value falls

20 Disadvantages of inflation to workers Advantages of inflation to workers Some workers expect higher wages, but do not get them due to lack of firm confidence (especially if firms cannot pass increased cost onto consumers) Increased unemployment (firms may cut costs if they cannot pass inflationary costs onto consumers) Workers suffer if wages or tax allowance does not increase in line (indexed) If wages are indexed, no effect Wages may not fall if in a trade union is a rise in the real value of money over time deflation is a fall in the rate of inflation disinflation Define the Phillips Curve A simplified observation that there is a possible trade-off between inflation and unemployment - less of one means more of the other

21 The Phillips curve displays a relationship between rate and rate Why might wages nominal wages rise when unemployment is low (Phillips Relationship) Why might money wages grow slowly, or even fall when unemployment is high? A rise in wages may result in a rise in the price level. Why is this? The Phillips curve implies a between inflation and unemployment negativeunemploymentinflation If unemployment is low (i.e more employed), there is less of a worker pool for firms to choose from. So the supply of labour is reduced, causing wages to rise: High wages need to be paid by firms to retain workers If more employed, firms receive more (higher consumption), so firms can afford to pay higher wages If less employed, consumption is lower, so firms cannot afford to pay high wages Firms do not need to pay high wages because they can choose from a large pool of unemployed (unemployed are desperate/willing to work for less) Rising wages: cost-push inflation, firms pass the higher cost onto consumers, causing price level to increase Rising wages: higher demand (consumption), so demand-pull inflation trade-off

22 Why does the Phillips curve illustrate a trade-off Because a government can only reduce unemployment at the expense of increasing inflation vice versa: More inflation = less unemployment There is a trade off between unemployment and inflation. e.g if the government tries to spend its way into reducing unemployment, they cause AD to, and an in wages to absorb the extra spending in the economy i.e inflation increaseincrerease If the government wants to cut unemployment, it might find that the level of wage inflation starts to rise, which might cause inflation.explain why this is... If there is a shortage of a particular type of worker, higher wages will need to be offered to attract workers from other jobs.as wages rise for some jobs, and spending more generally increases, other wages and prices will be bid upwards How did the Phillips curve help develop the shape of the AS curve? As price level increases ( inflation), unemployment falls. Therefore increasing price level leads to less spare capacity (because more workers are employed). Therefore AS becomes more inelastic as price level increases. Draw the shape of the shortrun Phillips curve

23 After 1966, what happened to the Phillips curve? It was not highly respected: the Phillips curve began to flatten and break down Suggest some possible causes for the flattening of the Phillips curve Globalisation: increased competition from abroad, so firms have less scope to raise prices, despite rising AD Labour mobility: low unemployment and high demand for labour attracts migrant workers, so wages do not rise as much Monetary policy helped anchor inflation despite changes to employment levels Reduced inflationary pressure due to supply side policies which increase AS