Inflation - 4
Definition of Inflation
· Inflation means a sustained increase in the general price level
· If there is inflation the value of money declines and there is an increase in the cost of living
Measuring Inflation: Retail Price Index (RPI)
1. Household expenditure survey- seeks to measure what people spend their money on. And therefore get a typical basket of goods.
2. This basket of goods gives a relative importance to each different item. E.g. if housing increased by 10% this would have more effect than an increase in radios
3. The basket of goods is updated each year to take into account changes in expenditure
4. Every month changes in prices of goods and services are monitored and combined into a single figure with using the weights in the basket.
Problems with calculating RPI
1. Family Expenditure survey does not include everybody e.g pensioners are excluded, but pensioners have different spending habits e.g. heating is more important. Young people will benefit more from falling prices of mobile phones
2. Changes in Quality: Computers have many more features than 10 years ago, so it is difficult to compare prices because they are different goods
3. One off shocks may distort RPI. E.G changes in tax rates or interest rates
Costs of Inflation
1. Cost of reducing inflation:
High inflation is deemed unacceptable therefore govts feel it is
best to reduce it. This will involve higher interest rates, the reduction in
AD will lead to a decline in economic growth and unemployment
2. International competitiveness:
Higher prices will make British goods less competitive, leading to a fall
in exports. However this may be offset by a decline in the exchange rate
3. Confusion and Uncertainty:
When inflation is high people are uncertain what to spend their money
On. Also when inflation is high firms may be less willing to invest
because they are uncertain about future profits.
4. Menu Costs.
This is the cost of changing price lists
5. Income redistribution.
Borrowers will become better off, lenders will become worse off,
however it depends on the real rate of interest.
Causes of Inflation
1. Demand Pull inflation
· If AD increases faster than AS inflation will occur. AD could increase for a variety of reasons such as higher consumer spending and expansionary Fiscal Policy
2. Cost Push Inflation
· If there is an increase in the costs of firms then firms will pass this on to consumers therefore there will be a shift to the left in the AS
· Cost push inflation can be caused by many factors:
1. Wage Push Inflation
trades unions can bargain for higher wages, this will lead to an increase in costs for firms. It may also cause demand pull inflation as consumers spend more.
2. Import prices
One third of all goods are imported in the UK. If there is a devaluation then import prices will become more expensive leading to an increase in inflation
3. Raw Material Prices, the best example is the price of oil, if the oil price increase by 20% then this will have a significant impact on inflation
4. Declining productivity
