Inflation

Key terms:

• Inflation – a persistent rise in the general price level in an economy over a period.
  
  
• Disinflation – a slow down in the rate of inflation.
  
  
• Deflation – a general fall in prices across an economy.
  
  

Two measures of inflation:

1. Consumer Price Index (CPI):
   
   

• It is a measure of a “basket of goods” – the goods are weighted based on their level of consumption to produce an index value.
  
  
• It is based on the “average household” (survey covers over 40,000 households).
  
  
• CPI doesn’t include the costs of the home (i.e. rents and mortgage payments). This allows a comparison between countries.
  
  
• The basket of goods contains around 600+ items.
  
  
• Some years some goods drop out and some goods are added in; weights also change to display changes in spending patterns.
  
  
  

1. Retail Price Index (RPI):
   
   

• RPI is very similar to CPI. However, the one key difference is that RPI includes household bills whereas CPI does not. 
  
  
• Examples of household bills are council tax and interest on loans.

Calculating rate of inflation using CPI
Two surveys are required: 

1. What people buy – this allows a weighting to be allocated to each group of items.
2. The prices of the goods and services (these are then converted into a price index).

Calculate a total index by multiplying each price index by its weighting and adding up all of the calculated figures. To find the new index for the year, divide this number by the total of the weightings.
Rate of inflation = percentage change.
Limitations of CPI inflation measure:

• The CPI only represents the “average” household: the weightings may not be fully representative for many families (e.g. fuel may have a high weighting, but this is not representative for a family who do not have a car).
• Housing costs: these costs are often associated with over 15% weighting, but they can vary vastly for different people. For example, a first-time buyer is likely to have a much higher housing cost weighting than a person who has paid off their mortgage.
• Changing quality of goods: the prices of goods often rise over time (especially true for technology) but CPI fails to reflect the change in quality. Therefore, it is tricky to compare goods over time.

Causes of Inflation:

• Demand-pull inflation: prices rise due to excessive demand in the economy (demand increase faster than supply).
• Cost-push inflation: inflation caused by an increase in the costs of production.
• Growth of the money supply: the amount of currency available in the system.

Impacts of increasing inflation:
On consumers: 

1. The real value of savings falls as prices rise so saving is less attractive.
2. As prices rise, the purchasing power of those on fixed incomes falls.
3. Those with high personal debt benefit as the real value of the debt falls.

On the government:

1. The real interest rate falls causing the cost of borrowing to fall.
2. Low inflation helps to protect against deflation which prevents underinvestment.

On firms:

1. High inflation causes the cost of exports to increase and the price of exports decreases which causes a worse balance of payments.
2. As the value of money falls, investment from abroad decreases.

On workers:

1. There is a trade-off between wage-inflation and unemployment as a high wage-inflation means it is easier to find work as firms increase wages as they cannot choose others at lower wages.