2.1.2 Inflation

• 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 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

Step 1: Study the time period and decide if you are witnessing inflation, disinflation or deflation

Disinflation

Step 2: Explain your answer

According to the CPI data, prices are still rising but at a decreasing rate. For example, in 2018 prices were rising at around 3%. In 2019 this increase fell to roughly 1.8%. In 2021, they were still rising but by a much lower 0.5%

• 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
  
  

Step 1: Calculate the CPI for 2020

Step 2: Calculate the CPI for 2021

Step 3: Calculate the percentage difference between the CPI for 2021 and 2020

• 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 & another the CPI
    
    
• The CPI does not capture the quality of the products in the basket
  • Product quality changes over time and 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 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 a households 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, & 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
  
  

A diagram that shows how an increase in aggregate demand raises the average price level in an economy

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/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
  
  

A diagram that shows how an increase in the costs of production raises the average price level in an economy

Diagram Analysis

• If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in productivity, 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 a wage-price spiral

The Impact Of Inflation On Different Stakeholders