Inflation

Inflation is a sustained rise in the average price of goods and services over a given time period.

Inflation means thee is a fall in the purchasing power of money. To beat inflation you need to invest and get higher returns than the inflation rate, or spend your money.

Macro Objective (UK) - 2% (±1%)

Disinflation - Reduction in inflation
Deflation - Sustained decrease in the average price of goods in services over a given time period

Types

Demand-Pull Inflation

Caused by excess aggregate demand.

• Often linked to a money and credit boom
• Economy close to full capacity
• Positive output gap.

Cost-Push Inflation

Inflation initiated by rising costs of production. For example:

• Rising wage costs in the labour market
• Increasing raw material and component costs from domestic and overseas suppliers.
• Rising import prices, often due to a falling exchange rate -> increasing import costs.

Money Stock

• Availability of credit
• The amount of current in circulation

Quantity Theory of Money - Fisher Equation

\(MV = PQ\)

Variable - Variable in SR and LR Constant - Constant in SR

Measuring inflation

Consumer Price Index

• Survey 40,000 households in order to research the most commonly purchased goods
• Create a basket of goods that contains 700 products to represent the economy
• Attach weightings to these goods based on their importance and how frequently they are purchased.

Limitations of CPI

• Not fully representative of some households - 14% of CPI is motoring costs
• Spending patterns - Single people have different spending patterns compared to those with children
• Quality - The CPI does not take into account changes in quality. Prices could rise but also be accompanied by higher quality, which would not be inflation.
• Slow to respond - CPI is slow to respond to new products and services. The CPI basket is changed every year but only a few items fall in / come out

Retail Price Index

Calculated in a similar way but includes more factors such as mortgage interest payments and council tax.

Expectations

When inflation becomes high, people expect it, meaning that they demand higher wages, and firms keep raising their prices because they can get away with it. This leads to inflation being "baked-in" to the economy.

See the philips curve for an example

Consequences of Inflation

Inflationary Noise

When inflation is high, it becomes difficult to compare prices / products since all prices are rising. Price signals also become less effective. Purchasing decisions become more complicated.

Menu Costs

Firms have to continually update their price list. This increases their admin costs as they have to update websites / catalogues.

Shoe Leather Costs

Individuals and firms don't want to hold on to their money since in real terms, it will lose value. Therefore they seek out the best interest rates from banks, even if it means frequently moving their money.

Fiscal Drag - Even at low inflation rates

The burden of tax can increase if tax brackets are not raised in line with inflation. If a worker gets a pay rise in line with inflation, this could push them into the next tax bracket, which would mean they are earning less money in real terms.

Business Confidence

If inflation is accelerating or fluctuating, it is difficult for businesses to plan for their future, so they will be less inclined to invest.

Loss of international competitiveness

Businesses can experience a loss in international competitiveness as rival economies could have more stable economies in comparison.

Depends Upon

The size of effects will depend upon:

• The amount of inflation
• Whether the inflation rate is stable or volatile
• Whether the inflation is anticipated / predicted

Positives

Since the Macro Objective is 2%, there must be some benefits.

Warning:

I am not very sure about these. Points 4. and 5. I found on the internet and seem to make sense, but weren't in lesson. no. 1 I don't understand, and no 2 and no 3 and the same if you actually expand them.

Benefits include:

• Indicator of stable growth
• Could be overstated by Measurement
• Avoiding a deflationary period.
• Low inflation encourages people to invest their money
• Firms are able to decrease people's wages, employees would be very unlikely to accept a pay cut

Deflation

A sustained fall in the average price of goods and services over a given time period.

Consequences of Deflation

Holding back spending

Consumers may postpone spending - they expect prices to fall in the future.

Debts increase

The real value of debt rises with deflation and higher real debts can be a big drag on consumer confidence. For example, for a mortgage.

Lower profit margins

Lower prices can mean reduced revenues and profits for businesses. This can lead to shedding labour causing higher unemployment. Higher unemployment means less customers so you shed more labour and get stuck in a cycle.

Can make exports more competitive

Deflation can make exports more competitive eventually, but it often comes at a cost in the short term.

Solving Inflation