# Inflation

A) Understanding of:

Inflation – An increase in the general price level of goods/services within an economy resulting in a decrease in the purchasing power of money.

Deflation – A decrease in the general price level of goods/services within an economy resulting in an increase in the purchasing power of money.

Disinflation – A decrease in the rate of inflation (the general price level is increasing, but at a slower rate than before) e.g. inflation falls from 5% to 4%.

B) The process of calculating the rate of inflation in the UK using the Consumer Prices Index (CPI)

Firstly a family expenditure survey is given out to thousands of households within the UK. These households will then make a record of the goods/services that they are spending money on as well as how much money they’re spending on each item. This will take place over a number of weeks.

Around 700 of the household goods/services that are the most popular will be put into a basket of goods/services. The basket of goods/services has a weighting system which indicates the percentage of a household’s income that is spent on the good/service. For example, if the household spends 20% of their income on milk, but only 5% of their income on bread, then milk will have a higher weighting than bread. This is an important part of CPI price increases on goods/services which take up a large proportion of a households income will have a bigger effect on the household than price increases on goods/services which only take up 1 or 2 percent of their income. These weighting are between 0 and 1 and the items in the basket of goods/services change each year in order to keep up with changes in consumer spending e.g. the goods/services that are being bought and how much households spend on them (for example, a recent addition to the basket of goods/services has been coffee pods).

A base year is then chosen. The index for this year is always expressed as 100 to make it easier to calculate inflation changes.

Index numbers are then generated giving a measure of the rate of inflation changes. For example, 2008 is the base year and therefore has an index of 100. In 2009 the index goes to 120. In order to find out the inflation rate for that year you work out the percentage change of these two numbers: 20(difference between the two index numbers)/100(the original index numbers) x100 = 20%.

 Category Price index Weighting Price x Weight Clothing 114 20 2,280 Food 96 5 480 Alcohol/Tobacco 112 14 1568 Household Items 100 8 800 Leisure Services 102 7 714 Transport 105 16 1,680 Housing 104 3 312 Other Items 102 27 2,754 100 10,588

The weights attached to the item are multiplied by the price index in order to get a figure for the money spent on each item in a given year. In order to work out the price index for the year you use the following formula: Price index for this year = the total sum of Price x Weight/the total sum of the weights. Therefore the price index for the table above is 10,588/100=105.88. To work out the inflation rate you find the percentage change between the base rate (100) and the new index number: 5.88/100×100=5.88%.

C) The limitations of CPI in measuring the rate of inflation

Basket may not represent all consumers spending habits – Although thousands of households are used in the family expenditure survey, it does not mean that the overall basket of goods/services will represent every households spending habits. This can result in the inflation figure being inaccurate for households whose shopping habits do not contain the majority of goods/services that are in the basket of goods/services.

Different measurements of inflation are used by different countries – Other countries may use different inflation measurements such as RPI. For example, CPI is often less than RPI as it doesn’t include housing costs and therefore this can make comparisons between countries using different inflation measurements difficult to make.

Prone to inaccuracy/errors – Like all data collection schemes, CPI is prone to errors and inaccuracies. This can result in the inflation rate being either undervalued or overvalued. This can be a major problem, especially when considering policy decisions can be made based upon the inflation rate of the economy.

Difficulty of past comparisons – The ever changing contents of the basket of goods/services can make inflation changes less relevant/useful when making comparisons to previous years. For example, the items in today’s basket of goods/services will be a lot different to those in the basket 5 years ago. Therefore, comparing the current inflation rate to the one 5 years ago will not be as useful compared to if the basket of goods/services didn’t change.

Consumption habits can change in less than a year – Changes in consumption and trends can happen throughout the year; however the basket of goods/services only changes every year. This can cause items in the basket of goods/services to become outdated during the year and therefore giving a less accurate representation of the inflation rate and the effect it will have on households. For example, there may be a consumption change half way through the year switching from instant coffee to coffee pods. However, this will not be accounted for in the basket of goods/services as it only changes every year. Therefore, if the price of coffee pods and other new items increase massively, then the inflation rate may be undervalued in comparison to the changes in the price level of households overall shop. This inaccuracy will then have to wait until the end of the year when the basket of goods/services updates again.

D) The Retail Prices Index (RPI) as an alternative measure of the rate of inflation

The main difference between RPI and CPI is that RPI takes into account housing costs such as Council tax and Mortgage interest payments. RPI is often higher than CPI as housing costs tend to increase at a relatively high rate. The only exception to this in recent times was in 2009 during the time of the financial crisis. In 2009 RPI plummeted as a result of near zero interest rates causing a major fall in housing costs.

E) Causes of inflation:

Demand pull

An increase in Aggregate demand (AD1 to AD2) causes an increase in real GDP (Y1 to Y2) and an increase in the general price level of goods/services within the economy (P1 to P2). The increase in the demand for the goods/services moves the economy closer to full employment, as a result of this; more pressure is being put on the existing factors of production, causing prices to rise. For example, if there is more demand for goods/services within an economy then in order for firms to meet this increased demand they may have to increase the number of employees on overtime or make existing employees work harder. Employees will notice this change in workload and are likely to ask for an increase in wages. In addition to this, labour will also become scarcer as firms hire more employees in order to keep up with the increase in demand. As demand for labour is derived from the demand for goods/services, the increase in AD will cause wages to increase. In both cases, wage inflation will occur. Consumers then have more disposable income which they will then spend on goods/service thus increasing inflation further (inflationary spiral). Any increase in the components of AD (Consumer spending, Investment, Government spending, Net trade) will cause demand pull inflation.

Cost push

A decrease in AS (AS1-AS2) causes a decrease in Real GDP (Y1-Y2) and an increase in the general price level of goods/services within an economy (P1 to P2). Reductions in Aggregate supply are caused by supply side shocks. For example, a decrease in the value of the UK currency will result in imports becoming more expensive. This causes imported commodities to increase in price. As a result of this, firms have to increase their prices in order to compensate for their increased costs. Anything that causes a decrease in AS and an increase in firms costs of production will cause cost push inflation e.g. oil prices, wages, VAT, Corporation tax. Cost push inflation is known to be the worst types of inflation for the economy due to the fact that Real GDP is decreasing as well as the fact that inflation is increasing, overall this can result in stagflation.

Growth of the money supply

The relationship between prices and the money supply is known as the quantity theory of money. The Fisher equation: MV (What is bought) = PQ (What is sold). (M= Money supply, V = Velocity of circulation, P = Average price level/inflation, Q = quantity of goods/services sold). In order to focus on inflation, the formula can be rearranged to get P on its own (P = MV/Q). Data suggests that M and Q are fixed. This means that although there may be some fluctuations in V and Q e.g. during recessions and booms, it is not significant and therefore is counted as a fixed amount. As a result of this, it can be concluded that the value P is equal to M. Therefore the price level of goods/services within an economy is equal to the money supply. This is summarised by the expression that if more money is chasing the same quantity of goods, prices will rise to compensate for this. The monetary policy of quantitative easing/increasing the money supply was used in the 2008 financial crisis by the UK government. It is used in order to encourage banks to lend money to consumers and firms resulting in an increase in spending and therefore an increase in the general price level of goods/services within the economy.

F) The effects of inflation on consumers, firms, the government and workers

Consumers

The main impact on the consumer is the reduction in purchasing power that is caused by inflation. This means that their weekly spending will not buy the same quantity of goods/services as it used to. The effect of inflation is likely to be relatively regressive meaning that it has a bigger impact on those with lower incomes as essentials such as bread increase in price. This is in contrast to those on higher incomes which are more likely to spend a much lower percentage of their weekly income on shopping/items in the basket of goods/services.

One of the benefits to consumers is that the real value of debt/loan repayments will decrease. As, loan repayments do not align with inflation the consumer will experience this benefit, leaving consumers with more disposable income to spend, thus increasing consumption.

Firms

One of the major problems of inflation to firms is that it is likely to result in an increase in the interest rate. This is due to the fact that the Bank of England will see the increase in inflation and try to control it by deterring consumption/investment thus reducing the upwards pressure on prices.