Inflation (AS/A LEVELS/IB/IAL)
Inflation (AS/A LEVELS/IB/IAL)
Level: AS Levels, A Level, GCSE – Exam Boards: Edexcel, AQA, OCR, WJEC, IB, Eduqas – Economics Revision Notes
Inflation
Inflation is a sustained rise in the general price level.
Deflation
Deflation is a fall in the general price level.
Disinflation
Disinflation is a fall in the rate of inflation. For example, inflation might fall from 4% to 3%. This means that prices are rising at a slower rate but not decreasing.
Hyperinflation
Hyperinflation occurs when inflation is totally out of control and rapidly accelerating to uncontrollable levels. It makes the value of money worthless and makes it extremely difficult for the economy to function normally.
Hyperinflation in Zimbabwe began in the late 1990’s. This happened shortly after the confiscation of private farms from landowners, towards the end of the Zimbabwean involvement in the second congo war. During the height of hyperinflation from 2008 to 2009, it was difficult to measure Zimbabwe’s hyperinflation because the government stopped publishing official inflation statistics. However it is estimated that inflation was around 79,600,000,000% per month.
How is inflation measured in the U.K?
Inflation is measured using an index such as CPI (Consumer Price Index). This is the official measure of inflation in the UK.
How is the consumer price index (CPI) calculated?
Two surveys need to be carried out to calculate CPI.
- Food and expenditure survey
- This involves collecting information from a sample of around 7000 households in the UK using self-reported diaries of all purchases including food eaten out.
- The proportion of income spent on each item is given a weight. E.g. If 10% of income is spent on food, then 10% of the weighting is assigned to food.
2. Price survey
- This is conducted by civil servants who collect data once a month about changes in the price of the 650 most commonly bought basket of goods services.
- They collect these prices from a variety of outlets which are high-end and low-end. They collect a variety of prices for each item.
- They collect around 120,000 prices in total.
- Price changes are multiplied by weights to give a price index.
- Inflation can be measured from this by calculating the percentage change in this index over consecutive years.
Limitations of using CPI in measuring the rate of inflation
- Difficult to make comparisons – it can be difficult to interpret when making comparisons with historical data as the figure is more recent. Estimates go back to 1988 but CPI was only used since 1996
- Not fully representative – impossible to take into account every single good that is sold and the amount of money spent on each good varies amongst different households. Therefore CPI only measures an average rate of inflation
- Does not include the price of housing – the data may present lower figures and CPI does not account for the price of housing, yet this is said to rise more than the price of goods
What is an index number?
This is a number showing the difference in a price or value compared with the base year. The base year is normally 100 for analysing economic data for your exams.
What is a base year?
A base year is the starting point used for comparison when measuring economic activity.
Causes of inflation
- Demand-pull inflation
- Cost-push inflation
Demand-pull inflation
This occurs due to an increase in aggregate demand. An increase in demand for goods and services in the economy normally leads to a rise in prices.
Cost-push inflation
This occurs due to an increase in the cost of production causing the aggregate supply curve to shift to the left. As costs rise for firms they will decrease their supply of goods and services. This will cause a rise in the price level of goods or services.
Retail Price Index
This is also a measure of inflation that includes housing costs. The main difference between CPI and RPI is that they both include slightly different things in their calculations. RPI includes the costs of housing (e.g. mortgage interest costs and council tax) while CPI does not.
Effects of Inflation on Consumers, Firms, the Government and Workers
Consumers
- Less Disposable Income – if wages do not increase with inflation, households will have less income to spend which may cause living standards to fall
- Less Consumer Confidence – inflation may cause psychological effects, resulting in consumers feeling less well off and their confidence to spend decreasing
- Less value for money – those who have saved will lose out as their money is worth less
- Those in debt will gain – consumer who are in debt will be able to pay it off at a price cheaper in value
Firms
- Less Competitive – British goods will be more expensive and their exports are likely to fall if the inflation in Britain is higher than in other countries
- Difficult to Predict Forecasts – it can be difficult to predict the inflation rates which makes it harder for businesses to plan ahead
- Possible change in Business Models – firms may have to alter their business models, making it cheaper to implement processes if inflation causes their costs to rise significantly high
- Less Business Confidence – if inflation remains high for a large period of time, firms may be reluctant to invest as their costs increase and they have less money available for investing
The Government
- Less Government Revenue – if the government do not increase taxes in line with inflation, its revenue will fall
- Real Government Income will rise – if the government do not change the personal income tax allowance, tax payers will have less money and the government will generate more income
Workers
- Lower Living Standards – if workers do not receive annual pay rises when inflation occurs, they will end up worse off, reducing their living standards
- Higher Unemployment – if inflation is persistent, businesses’ costs will increase meaning they have less of their budget available to hire new workers. This causes unemployment to rise as there is an excess supply of workers
WJEC Spec – Additional Content
Other causes of Inflation
Wage-price Signal
Higher wages mean households have greater disposable income and more money to spend. This results in increased aggregate demand, as well as inflation.
Firms are also faced with higher costs of production as wages increase, putting upward pressure on the average price level in the economy – this causes a spiral to arise
Money Supply
As the money supply grows, hyperinflation is likely to be caused if national output does not increase correspondingly
Solutions to Inflation
- Demand Pull inflation can be reduced by implementing deflationary fiscal and monetary policies
- Higher taxes can reduce the disposable income households have and hence cause aggregate demand to fall. This would also decrease inflation. However, workers may in turn demand higher wages to compensate for the increase in taxes – this would increase the costs of production and reduce the productive capacity of the economy
- Higher interest rates will encourage consumers to save and deter them from spending – this would cause investment and consumption to decrease, hence aggregate demand and inflation will also fall
Quick Fire Quiz – Knowledge Check
1. Define inflation (2 marks)
2. Identify what measure is used in the UK to measure inflation (2 marks)
3. Explain how inflation is calculated? (8 Marks)
4. Identify what the target rate of inflation is in the UK (2 marks)
5. State what the retail price index (RPI) is (2 marks)
6. Explain the difference between RPI and RPI – X (4 marks)
7. Explain the difference between RPI and CPI (4 marks)
8. Identify and explain the 7 problems with the measure of CPI (8 marks)
9. Define Demand Pull Inflation (2 marks)
10. Define Cost Push Inflation (2 marks)
11. Explain the disadvantages of inflation (8 marks)
12. Explain the benefits of inflation (8 marks)
13. Explain the limitations of using CPI to measure the rate of Inflation (6 marks)
14. Explain the effects of Inflation on Consumers (4 marks)
15. Explain the effects of Inflation on Firms (4 marks)
16. Explain the effects of Inflation on the Government (4 marks)
17. Explain the effects of Inflation on Workers (4 marks)
Next Revision Topics
A Level Economics Past Papers
