2.1.2 Inflation Edexcel A Economics Notes

Contents

Definitions

Inflation is a persistent increase in the price level.

Deflation is a persistent fall in the price level.

Disinflation is a fall in the rate of inflation.

How to measure inflation

To measure the rate of inflation, we calculate the percentage change in the price level.

• A 2% inflation rate means the price level has risen by 2%, (usually) compared to the price level 12 months ago.

The consumer price index (CPI) measures inflation using a “basket of goods”. 

• CPI initially assigns each good a “weight”.
• The more spending on this good by the average household, the greater the weight.
• Statisticians measure the change in price of each good compared with 12 months ago.
• Then, use the weights to create an average.

CPI is helpful as:

• It allows us to measure the changes in price level over time.
  • This can be useful for the central bank when setting monetary policy or for the government when setting fiscal policy.
  • This may also be helpful for firms for planning how much to raise their price or as an indication of the level of demand for goods and services.
• We can compare the rate of inflation between different countries.

However the drawbacks of CPI as an inflation measure include:

• There are different inflation rates for different groups.
  • For example suppose food and energy prices go up very quickly but not the prices of luxuries. Then those on low incomes may see an even greater inflation rate, compared to those on high incomes.
  • However the CPI rate only gives one inflation rate and does not represent the price level changes faced by different groups.
• CPI does not account for mortgage costs.
• CPI does not capture quality changes.
  • The quality of some goods may improve over time. For instance, computers and mobile devices have become more powerful. So, even if you pay a little more for your phone now than in the past, consumers may still be getting greater value for money as technology improves.
  • However the CPI does not account for changes in quality.
• CPI Does not account for the substitution effects.
  • As the price of one good rises, consumers will reduce the quantity of that good. They will also substitute towards other goods whose prices have not risen. So the quantity demanded for other goods also changes.
  • This means the CPI basket weights for different goods should change, when one price changes. However the CPI weights do not change in this way.

What are the causes of inflation?

There are three key causes of inflation for Edexcel A Economics:

Demand pull inflation

• Demand pull inflation is inflation caused by aggregate demand shifting right.
• For example, an increase in government spending leads to a shortage of goods or services at current price level. So the price level rises to ration the excess aggregate demand.*
• The diagram shows demand pull inflation. AD shifts right from AD to AD1. This results in the price level rising from PL to PL1, in other words inflation.

Cost push inflation

• Cost push inflation is inflation caused by aggregate supply shifting left.
• For example, higher energy costs for firms lead firms to pass on some of energy cost rise to consumers, with higher prices. This creates inflation.
• The diagram shows SRAS shift left from SRAS to SRAS1. This increases the price level from PL to PL1, resulting in inflation.
  • This depends on how reliant firms are on the particular input driving the cost-push inflation.
  • In the case of a rise in energy prices, some firms might not rely very much on energy and instead rely on labour.
  • The dependence on energy may also fall over time, due to energy efficiency measures and switching to cheaper substitutes.
  • These firms would not see rising costs, so SRAS shifts left to a lesser extent.

Growth of the money supply

• The “quantity equation” is MV = PY
  • Where M = money supply
  • V = velocity of money (how often money changes hands)
  • P = price level
  • Y = real GDP.
• Assume V and Y are fixed (at least in the long run).
• Then doubling M means more money chasing the same number of goods, so P doubles (inflation). This is called the quantity theory of money.
• In other words, increasing the money supply causes inflation.
• However there are challenges to this theory.
  • V may not be constant over time. For example, the velocity of money may increase in booms and decrease in downturns.
  • Y may not be constant over time.

What are the consequences of inflation?

Households

• Inflation lowers real incomes if inflation outpaces wage growth.
  • This particularly affects those with fixed incomes or whose incomes rise more slowly than inflation.
  • This reduces purchasing power, leading to lower consumption and lower aggregate demand as a result.
  • This can result in a movement along the AD curve (a contraction).
• Savers are worse off. Borrowers are better off.
  • Inflation reduces real value of savings, which makes savers worse off.
  • Inflation reduces real value of debt relative to other goods. This makes borrowers better off.
    • This depends on response of interest rates to inflation. High inflation may encourage the central bank to raise interest rates, to bring the rate of inflation. High interest rates may compensate savers for some of the fall in the real value of savings. Higher interest rates may also make it more expensive to borrow.
• Households may bring forward consumption.
  • If consumers expect inflation to continue, this means goods will be cheaper today compared to their prices in the future.
  • So consumers may increase consumption today.
• Households may face shoe leather costs.
  • In times of high inflation, cash loses value much more quickly relative to prices in the economy (compared to when there is zero or low inflation).
  • So in times of high inflation, consumers are likely to hold more of their money in the bank, where the money is receiving interest.
  • However consumers may need cash to make purchases.
  • So, in times of high inflation, consumers must make extra trips to the bank and withdraw less cash each time, in order to keep as much of their money in the bank at any given time as possible.
  • Shoe leather costs cover the time and cost of making trips to the bank
  • The phrase comes from the fact that households’ shoe leather is worn down from walking to and from the bank more often.

Firms

• Firms may face higher costs under cost-push inflation.
  • Firms may pass on some of the higher costs to consumers in the form of higher prices.
  • However higher costs are likely to reduce profits, as firms may not be able to pass on the entire cost increase to consumers, without losing demand.
• Inflation reduces the price competitiveness of exports.
  • This reduces export demand and can lead to a shift left in aggregate demand.
  • On an AS-AD diagram, this can be shown as a movement along the AD curve (a contraction).
    • This depends on what happens to inflation rates in other countries.
    • If the rate of inflation is even higher abroad, then even if there is domestic inflation, export price competitiveness can improve.
• Menu costs – costs to business of updating price information.
  • When there is inflation, firms have to change their prices. This can involve writing a new menu for instance, which comes at a cost to the business.
    • However menu costs might be smaller for online businesses, who can change their prices with a few clicks.
• Uncertainty for firms:
  • Inflation makes firms less certain about future prices.
  • This leads to firms being uncertain about their costs, revenues and hence profits.
  • This is likely to reduce investment.
    • However if central banks act to reduce inflation, for instance by raising interest rates, this may bring inflation down. This would make firms more certain about the future path of the price level.
• Wage price spiral.
  • Inflation may lead to workers asking for higher wages, so that their wages take into account inflation.
  • Higher wages in turn increase production costs, so firms may increase prices to maintain profit margins.
  • This may lead to even higher wage demands, leading to even greater increases in prices.

Workers and the government

Workers

• Workers may experience a fall in real wages. This occurs if the inflation rate exceeds the rate of increase in nominal wages.
• This assumes workers suffer from “money illusion“. If inflation occurs but their nominal (cash) wages remain the same, money illusion is when some workers do not appreciate their real wages have fallen even though their nominal wage has remained the same.
  • However if workers take into account that inflation has risen when bargaining for pay, they may ask for wage rises to match inflation. This would mean overall that real wages remain constant.
• To restore real wages, there may be increased strike activity by trade unions.
• Workers may suffer from fiscal drag. If tax thresholds are not adjusted in line with inflation, then as worker pay rises with inflation, workers may be dragged into higher tax bands, paying higher marginal tax rates.
• Cost-push inflation increases costs and reduces firm profits. This may lead firms to fire workers, increasing the rate of unemployment.
  • However demand-pull inflation may be a sign of a growing economy. In that case, we would expect higher firm profits and higher demand for labour, reducing the rate of unemployment.

Government

• Suppose the government is a borrower. Then inflation benefits the government, as the real value of debt falls, making debt easier to repay in the future.
  • However the central bank may respond to inflation by raising interest rates. This would increase the level of interest payments the government has to pay, which may increase government spending and increase the budget deficit.
  • Also, some government debt is linked to inflation. For index-linked bonds, interest payments are directly adjusted in line with inflation rates.
• Inflation may increase the costs of running publicly owned companies or public services. This may increase government spending and increase the budget deficit.
• However inflation may increase tax revenue, as wages and profits may rise when there is inflation.
• Fiscal drag, as mentioned under the workers section, may further raise tax revenue for the government in times of high inflation.

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