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Understanding Inflation: Causes and Effects

This document defines and discusses inflation and deflation. It notes that inflation is measured by consumer price indices and is expressed as an annual percentage increase in prices. Inflation can be caused by demand-pull factors like tax cuts increasing demand, or cost-push factors like increasing wages or input costs. Deflation is a sustained fall in prices and can create a deflationary spiral where falling prices reduce demand and sales, forcing more price cuts. The UK government established controlling inflation as a top objective in 1979 and uses interest rate policies to influence inflation.

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12 views2 pages

Understanding Inflation: Causes and Effects

This document defines and discusses inflation and deflation. It notes that inflation is measured by consumer price indices and is expressed as an annual percentage increase in prices. Inflation can be caused by demand-pull factors like tax cuts increasing demand, or cost-push factors like increasing wages or input costs. Deflation is a sustained fall in prices and can create a deflationary spiral where falling prices reduce demand and sales, forcing more price cuts. The UK government established controlling inflation as a top objective in 1979 and uses interest rate policies to influence inflation.

Uploaded by

donage10
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd

INFLATION

• Inflation = SUSTAINED rise in the AVERAGE level of all prices


• Cause the Power of Money to fall

• Measured by = CONSUMER PRICE INDEX (Europe consistency)


• CPI = weighted average price of a typical basket of goods and services a
household might produce
• RETAIL PRICE INDEX = CPI + mortgage interest payments
• Base year 2005  value of 100  average year = no booms no busts

• Expenditure and Food survey  records 6000 household spending over 2


week period  weightings added, relative importance in the typical
household’s expenditure
• Current prices from 150 locations
• Average price of basket calculated to give 2nd index value  compare with
base

• Accuracy depends on contents + weightings + prices being correct


• Inflation is expressed as an annual % increase (but index is the formal way)

• DEMAND-PULL inflation  higher prices = increase in aggregate demand


(firms unable to supply quickly enough to meet demand)
• Full economic employment = impossible for agg. Supply to respon to extra
demand = Maximum inflationary pressure
• More demand caused by = TAX CUTS + LOWER INTEREST RATES +
HIGHER GOV SPENDING + LOWER EXCHANGE RATES

• COST-PUSH inflation  caused by HIGHER COSTS OF PRODUCTION


• Higher CoP caused by  Wages rising faster than labour productivity
 Rising interest rates
 Raw material expensiveness
 Fuel Prices increasing
• Cost-push inflation can cause an INFLATIONARY SPIRAL (death spiral)
• Death spiral  +CoP = +prices = +wages = +CoP
• Cost-push inflation often = IMPORTED INFLATION  import rise when
exchange rates fall

• Monetarist view  Aggregate demand rises too quickly for aggregate supply
to adjust  Too much money chasing too few goods
• Increase in aggregate supply = reduce inflationary pressure
• Monetarist rule = keep SUPPLY OF MONEY growing at same rate as the
ECONOMIC GROWTH
• Gov controls inflation and 2% +- 1% because:
1. inflation creates UNCERTAINTY in firms  lower growth
2. REDISTRIBUTION of INCOME  pensioners + wage rise faster
than inflation
3. Savers Loose  Borrowers Win
4. Menu Cost
5. Shoe leather cost  shop around  time and money
6. U/E  goods less competitive in international markets  export sales
fall + import purchases rise
• SURUMS

DEFLATION
• = sustained fall in the general price level
• DEATH SPIRAL  prices continue to fall = people don’t purchase
expecting lower prices = businesses have fewer sales = reduce prices and kick
staff = + u/e = reduced aggregate demand = prices fall
• If people expect low inflation – likely to demand higher wage increases 
self-fulfilling prophecy

• UK GOV EST 1979  most important macroeconomic objective


• 1979  England’s Monetary Policy Committee  control inflation by
manipulating base interest rates
• Interest rates reflect the PRICE OF MONEY
• The TRANSMISSION MECHANISM (18-24 months)

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