Inflation (Edexcel A Level Economics A): Revision Note

Inflation, Deflation & Disinflation

• Inflation is the sustained increase in the average price level of goods/services in an economy

  • The average price level is measured by checking the prices of a 'basket' of goods/services that an average household will purchase each month

  • This basket of goods is turned into an index and it is called the consumer price index (CPI)

  • The UK has an inflation target of CPI at 2% per annum

    • Low inflation is better than no inflation, as it is a sign of economic growth

• Deflation occurs when there is a fall in the average price level of goods/services in an economy

  • Deflation only occurs when the percentage change in prices falls below zero %

• Disinflation occurs when the average price level is still rising, but at a lower rate than before

  • These figures demonstrate disinflation:  Y1 = 5% Y2 = 4% Y3 = 2%

    • Inflation is increasing but at a decreasing rate

Calculating Inflation Using the Consumer Price Index (CPI)

• Inflation is the sustained increase in the average price level of goods/services in an economy

• The inflation rate is the change in average price levels in a given time period

  • The inflation rate is calculated using an index with 100 as the base year

  • If the index is 100 in year 1 and 107 in year 2, then the inflation rate is 7%

• The UK uses two inflation indices - the consumer price index (CPI) and the retail price index (RPI)

  • Each is calculated slightly differently

The Consumer Price Index (CPI)

• A 'household basket' of 700 goods/services that an average family would purchase is compiled on an annual basis

  •  A household expenditure survey is conducted to determine what goes into the basket

  • Each year, some goods/services exit the basket and new ones are added

• Goods/services in the basket are weighted based on the proportion of household spending

  • E.g. More money is spent on food than shoes, so shoes have a lower weight in the basket

• Each month, prices for these goods/services are gathered from 150 locations across the UK

  • These prices are averaged out

• The price x the weighting determines the final value of the good/service in the basket

  • These final values are added together to determine the price of the 'basket'

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• The percentage difference in CPI between the two years is the inflation rate for the period
  

The Limitations of Using the CPI

• The CPI provides a level of inflation for the average basket and the basket of many households is not the average basket

  • Depending on what households buy, the level of inflation for each one can vary significantly

  • As an average, it also ignores regional differences in inflation, e.g. London inflation may be much higher than Harrogate inflation

• The CPI is one of several methods used by countries in determining inflation; another is the retail price index (RPI)

  • This can make comparisons between countries less meaningful, as one may use the RPI and another the CPI

• The CPI does not capture the quality of the products in the basket

  • Product quality changes over time, so the comparison with different time periods is less useful

• The CPI only measures changes in consumption on an annual basis

  • Changes in consumption can occur more frequently and the index is always behind these changes

• The CPI is prone to errors in data collection

  • It is based on a survey that goes to thousands of households each year, yet it is still a small sample

  • The respondents have no incentive to fill in the survey carefully and accurately

The Retail Prices Index (RPI)

• The retail price index (RPI) is calculated in exactly the same way as the CPI

  • Certain goods/services that are excluded from the CPI are included with the RPI

    • These include council tax, mortgage interest payments, house depreciation, and other house purchasing costs such as estate agents fees

• Due to the extra inclusions, inflation measured using the RPI is usually higher than the CPI

  • This is mainly due to its sensitivity to interest rate changes, which affect mortgage interest

  • It's argued that the RPI is a more accurate indication of household inflation

The Causes of Inflation

• An increase in the average prices in an economy can be caused by demand-pull inflation, cost-push inflation, an increase in the money supply, and an increase in wages

Demand-pull inflation

• Demand-pull inflation is caused by excess demand in the economy

• Aggregate demand (AD) is the sum of all expenditure in the economy

  • AD = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)

• Short-run aggregate supply (SRAS) is the total supply provided in the economy at a given average price level
  

Diagram analysis

• If any of the four components of AD increase, there will be a shift to the right of the AD curve from AD₁ → AD₂

• At the original price (AP₁), there is now a condition of excess demand in the economy

• As prices rise, there is a contraction of AD and an extension of SRAS

• Prices for goods and services are bid up from AP₁ → AP₂

• Demand pull inflation has occurred

Cost-push inflation

• Cost push inflation is caused by increases in the costs of production in an economy
  

Diagram analysis

• If any of the costs of production increase (wages, raw materials, etc.), there will be a shift to the left of the SRAS curve from SRAS₁→SRAS₂

• At the original price (AP₁), there is now a condition of excess demand in the economy

• As prices rise, there is a contraction of AD and an extension of SRAS

• Prices for goods/services are bid up from AP₁→AP₂

• Cost-push inflation has occurred

Changes to the money supply

• If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms and consumers

  • This will result in an increase in consumption and investment

  • It is likely to lead to a form of demand-pull inflation

• The Central Bank can also increase the money supply through quantitative easing

  • This will result in increased liquidity and lower interest rates

  • It is likely to lead to a form of demand-pull inflation

Changes to wages

• Increased aggregate demand in an economy causes demand pull inflation

• Workers now feel less well off as their wages no longer have the same purchasing power

• Workers may demand wage increases to compensate for the higher prices

• Those wage increases are now a form of cost-push inflation (increased costs of production) and drive prices even higher

• This economic phenomenon is called the wage-price spiral

The Effects of Inflation

The Impact of Inflation on Different Stakeholders