Inflation is a rise in the general price level and a consequent fall in the purchasing power of money. Deflation is a persistent fall in the general price level which causes the rate of inflation to become negative. Disinflation is a fall in the rate of inflation which is not sufficient to bring about deflation, prices are still rising but at a slower rate.
How is inflation measured?
There are two main measures of inflation: Consumer Price Index (CPI) and Retail Price Index (RPI).
CPI:
- The CPI uses a weighted average of a basket of goods and is used by the government as the official measure.
- It is measured against the government target of 2% but doesn’t involve housing costs such as council tax and mortgage repayments.
- It is slow to react to new goods and services
- It also doesn’t accommodate the fact that different demographics have different spending patterns and therefore the basket of goods may not be representative of all households.
RPI:
- This includes housing costs.
- Usually has a higher value than the CPI due to the additional costs.
- It may be more accurate and representative as housing costs make up 16% of the index.
Real values – adjusted for inflation, for example if the GDP grew by 4% one year but there was also 2% inflation in the same year, the real GDP growth is 2% .
Nominal values – they are not adjusted for inflation and can make growth seem higher than reality e.g. in the above example GDP would seem 4% higher rather than only 2%.
These adjustments are applied to data using constant and current prices. Constant prices consider inflation (real values) whilst current prices do not consider inflation (nominal values).
CAUSES OF INFLATION
Demand-pull à Caused by unsustainable growth of AD and puts pressure on resources. Profit-maximising firms can increase prices and gain profits. It is from the demand-side of the economy
Cost-push à Caused by increasing costs for firms, it is from the supply-side of the economy.
This can be caused by changes in world commodities or increased costs of labour due to the influence of trade unions. Businesses then must increase prices to consumers to maintain profit margins.
EFFECT OF INFLATION ON FIRMS
- Loss of international competitiveness on a global scale if inflation is high and firms will be less price-competitive. Also, less competitive in comparison to imported products.
- Unpredictable inflation will affect business confidence and create uncertainty which will reduce investment.
- If inflation is high, interest rates will likely also be high, which means the cost of investment is higher.
- There is a reduced value of real debt for existing loans.
- Menu costs – additional costs of fluctuating prices.
THE IMPACT OF INFLATION ON INDIVIDUALS
- Workers
- Real incomes fall with inflation, so workers will have less disposable income which will reduce consumer spending, decreasing AD.
- If firms face higher costs, there could be more redundancies when firms try and cut their costs.
- Consumers
- Those on low and fixed incomes are hit hardest by inflation, due to its regressive effect, because the cost of necessities such as food and water becomes expensive.
- The purchasing power of money falls, which affects those with high incomes the least, those on benefits/pensions suffer most.
- Savers and borrowers
- Savings are worth less meaning that these people are less wealthy as their money has less purchasing power.
- The value of repayment will be lower for borrowers, because the amount owed does not increase with inflation, so the real value of debt decreases.