Problems with CPI
Different income earners may experience a different rate of inflation when their pattern of consumption is not accurately reflected by the CPI.
The wieghts of particular products are fixed so the inflation rate may be overestimated.
Substitution bias: if the price of a product in the sampled basket of goods increases, then consumers may begin to purchase a cheaper alternative. Therefore, the CPI would be overestimated as it would still be based on the original product.
New product bias: new products are not immediately taken into account in the CPI calculations, which may make the inflation rate less accurate espically if these new products become suddenly very popular.
New retail outlet bias: new retail outlets may also not be sufficiently sampled.
Quality bias: improved quality of goods and services may not be considered in the construction of CPI.
Core inflation: economists measure a core/underlying rate of inflation to eliminate the effect of sudden swings in the prices of food and oil, for example.
Producer price index (PPI): measures changes in the prices of factors of production may be useful in predicting future inflation.
Causes of inflation
Demand pull inflation: this tends to happen when the economy is reaching full employment. An increase in any components of AD which then cause AD to increase will in turn rise the average price level, and therefore demand pull inflation.
Exchange rate depreciation: this increases the price of imports and reduces foreign prices of UK exports. If consumers buy fewer imports, while foreigner by more exports, AD will rise, as the value of (X-M) increases.
Reduced direct or indirect taxation: consumers will have more real disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond potential GDP.
Rapid growth in money supply: perhaps due to increased bank lending and low interest rates. Consumers and firms are more able to borrow money and therefore spend more on goods and services causing AD to rise.
Confidence: an increase in the value of assets, such as higher house prices, may cause people to gain confidence (wealth effect) and therefore increase consumption.
Economic growth in trading nations: this may give a boost to exports and so increase AD.
Keynesian diagram showing demand-pull inflation
Classical diagram showing demand-pull inflation
Cost-push inflation: when the costs of production to a nations firms increases. A primary determinant of the SRAS curve is the productivity of a nations resources and the costs of production, therefore an increase in the costs of production will shift the SRAS to the left.
Incease in oil prices: oil is used in an incredible amount of production processes, so this would incearse many firms costs of production and lead to higher prices.
Increase in the National Minimum Wage: trade unions in some countries have the power to bargain for increases in the national minimum wage. An increase in this, or its implementation, raises costs of production and reduces production, so unemployment rises.
Currency depreciation: if the value of the currency falls then the relative price of imports increases. These imports may be raw materials or semi-finished products used in the production process that will increase the costs of production to firms. If the imports are finished products then this will directly increase the price level. With higher priced imports domestic firms also have less incentive to reduce costs and they face less competition which can lead to higher prices.
Natural factors/war: natural disasters can destroy a nations infrasture and reduce their productive capacity. This will increase a firms costs of production and reduce national output. Poor weather can destroy crops or reduce the yields and this can lead to higher prices of foodstuffs.
Higher taxes: corporate taxes will increase a firms costs of production and may result in an increase in prices. In addition a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in a standard rate of sales tax (e.g. VAT) or an extention to the range of products to which sates tax is applied. These taxes are levied on producers who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation.
Diagram showing cost-push inflation
Consequences of inflation
The severity of the consequences of inflation depends on whether or not it has been anticipated.
Anticipated inflation: when people can accurately predict the inflation rate, they can take steps to protect themselves from its consequences. For instance, trade unions may negotiate with employers for increases in money wages so as to protect the real wages of union members. Households may also switch savings into deposit accounts that offer a higher nominal rate of interest. People can therefore protect the real value of their financial assets. Firms may also adjust their prices or buy more raw materials in advance, to avoid higher costs of production and protect their profit margins.
Unanticipated inflation: prediction about inflation become very difficult to make when the rate of inflation is particularly volatile. Unanticpated inflation is when economists make errors in their inflation forecasts. This means that the effects of inflation are exacibated as people cannot adequately prepare for it.
Money illusion: this is when money, such as in the form of wages, appears to increase in value. However, in reality this is merely due to inflation. Therefore, although the nominal value is increasing, the real value is not.
Savers: inflation leads to a rise in the general price level so that money loses its value. When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if nominal interest rates are lower than inflation – leading to negative real interest rates.
Wage demands: inflation can get out of control because price increases leads to higher wage demands as people try to maintain their real living standards. Businesses then increase prices to maintain profits and higher prices then put further pressure on wages. This process is known as a ‘wage price spiral’. Rising inflation leads to a build up of inflation expectations that can worsen the trade-off between unemployment and inflation.
Redistribution of income: inflation tends to hurt those employees in jobs with poor bargaining power in the labour market – for example people in low paid jobs with little or no trade union protection may see the real value of their pay fall. Inflation can also favour borrowers at the expense of savers as inflation erodes the real value of existing debts. And, the rate of interest on loans may not cover the rate of inflation. When the real rate of interest is negative, savers lose out at the expense of borrowers.
Investment: budgeting becomes very difficult because of the uncertainty created by rising inflation of both prices and costs – and this may reduce planned capital investment spending. Lower investment then has a detrimental effect on the economy’s long run growth potential.
Balance of payments: inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance. If inflation in the UK is persistently above our major trading partnerss, British exporters may struggle to maintain their share in overseas markets and import penetration into the UK domestic market will grow. Both trends could lead to a worsening balance of payments.
Unemployment: as firms’ costs of production rise production becomes less profitable and firms reduce their output as a consequence and therefore less labour is required to produce lower levels of output.
Menu costs: costs associated with firms having to change price lists, reprogramme computers, change vending machines etc to deal with the higher prices.
Shoe leather costs: during times of rising inflation consumers find it difficult to know what price to pay for certain goods and services and therefore spend much more time ‘shopping around’ to check whether the prices they have been quoted are appropriate.
Relationship between inflation and unemployment (HL)
In 1958, Alban Philips found that there was a trade-off between the inflation rate and the unemployment rate of an economy. He suggested that falling unemplyment might cause rising inflation and a fall in inflation might only be possible by allowing unemployment to rise. Therefore, if a government wanted to reduce unemployment, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the product markets.
Reasons for trade off:
The labour market: as unemployment falls, labour shortages may occur where skilled labour is in short supply. This puts pressure on wages and prices to rise.
Other factor markets: cost push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass.
Product markets: rising demand allow suppliers to lift prices to increase profit margins. The risk of rising prices is greatest when demand is out stripping supply capacity.
As a result of supply shocks, such as natural disasters or wars, the SRAS curve may decrease. As shown in the diagram this means that the inflation rate (average price level) would increase but real GDP would decrease, therefore increasing unemployment. This means that the economy is experiencing stagflation – inflation accompanied by stagnant growth, unemployment or recession. This in turn causes the philips curve to move upwards and to the right as inflation and unemployment has increased.
Classical economists accept that the short run philips curve existed – but that in the long run, the philips curve should be drawn vertical and, as a result, there would be no trade-off between unemplyment and inflation.
The classicalists highlighted that each short run philips curve was drawn on the assumption of a given expected rate of inflation. So if there were an increase in inflation caused by monetary expanision and this had the effect of driving inflation expectations higher, then this would cause an upward shift in the short run philips curve.
The classical view is that attempts to boost AD to achieve faster growth and lower unemployment have only a temporary effect on jobs. Friedman argued that a governmnet could not permanently drive unemployment down below the natural rate – the result would be higher inflation which in turn would cost jobs and hit growth but with inflation expectations also increased.
With reference to the diagram, if the government increases AD to reduce unemploymnet, then initially unemployment will fall from U1 to U2, but inflation will rise to r. So there is a movement along the SRPC. However, some workers who accepted a job in the belief that there real wage had increase, would realise that due to inflation there purchasing power had not increased and so leave the labour market. In addition, those remaining in the jobs would demand higher wages and firms’ costs of production will rise, therefore, firms will reduce output and labour so PC1 moves outwards to PC2.
Economic growth: increase in real GDP through time.
Economic growth is depicted on a production possibilities curve (PPC) by an outward shift as the economy’s actual output increases.
A point within the PCC, like A, moves closer to the PPC, like B, due to various factors including a decline in unemployment and an increase in productive efficiency. This means that the actual output increasing closer to the potential output as existing resources are being used more fully. On the AD/AS diagram this actual growth is illustrated by an increase in AD.
When the quality and quantity of factors of production increases the volume of output increases and the economy experiences an increase in its potential output. Therefore, the PPC increases from PPC1 to PPC2. On the AD/AS diagram this potential growth is illustrated by an increase in LRAS.
Improved labour productivity is necessary to achieve economic growth in the long run, as it implies greater output per worker. In order to create greater productivity investment in natural, physical and human capital is required. Improvements in institutional framework are also needed.
Consequences of economic growth:
Living standards: if economic growth is greater than population growth, then it may result in higher real incomes and therefore improved living standards.
Unemployment: when the economy expands, unemployment tends to fall as more employees are required to expand production. However, jobless growth can occur if inappropriate technologies that do not rely on labour are utilised.
Inflation: if the growth in demand exceeds the growth of the productive capacity then higher incomes may cause the economy to overheat. Demand pull inflation may result from economic growth if it causes AD to increase too quickly. Also cost push inflation may be created if the growth puts pressure on input prices. However, non-inflationary growth is possible if the LRAS increases at least as fast as AD.
Distribution of income: economic growth tends to reduce government spending and increase government revenue as fewer people require transfer payments and more people pay higher rates of tax due to increases in real wages. The government is then able to fund redistribution programmes with the additional revenue. However, if the government were not to do this then the benefits would likely be unbalanced, with certain regions or areas profiting more than others.
Balance of payments: if growth is export driven then the trade deficit will decrease and a trade surplus may result. However, if it is due to domestic demand, then households may spend more on imports and therefore the trade deficit may widen.
Sustainability: economic growth may threaten sustainability as industries create many externalities, such as air, water and sound pollution. Firms may not take account of the future and therefore exhaust resources.
Equity in the distribution of income
Equitable: fair, not necessarily equal. Due to the unequal ownership of factors of production, the market system may not result in an equitable distribution of income.
Measuring income inequality:
Inequality ratios: the ratio of disposable income of the the top 10% (decile) over the bottom 10% of the population.
Lorenz curve: a curve showing the proportion of national income earned by a given percentage of the population.
Gini coefficient: the ratio of the area between the Lorenz curve and the diagonal over the area of the half square.
=(area A)/(area A + B)
0=total equality 1=total inequality
Absolute poverty: the minimum income necessary to satisfy basic physics needs.
Relative poverty: the extent to which a household’s income falls below the national average.
Those with low incomes have low human capital as they cannot afford the opportunity cost of schooling. However, they also do not have the funds to invest in physical capital and often deplete the natural capital in order to survive. This results in low productivity which in turn creates a poverty trap. Therefore, living standards remain low and individuals continue to be unable to access health care and education.
Taxation to redistribute income:
Direct taxes: taxes whose burden cannot be shifted onto someone else. This is because they are on income, profits or wealth. For example, income tax.
Indirect taxes: taxes whose burden can be shifted onto someone else. This is because they are on goods and expenditures. For example, sales tax.
Direct can be used in order to redistribute income.
Marginal tax rate (MTR): the extra tax paid due to an extra pound earned.
Average tax rate (ATR): the ratio of tax collected over the tax base, which is the amount taxable such as income.
Progressive tax: the higher income individuals pay proportionately more as the marginal tax rate is greater than the average tax rate. In most societies income taxes are progressive in order to redistribute income.
Proportional tax: the higher income earners pay proportionately the same as low income individuals as the marginal tax rate is equal to the average tax rate.
Regressive tax: the higher income earners pay proportionately less as the marginal tax rate is less than the average tax rate. For example, sales tax.
Governments undertake expenditures to provide directly, or to subsidize, a variety of socially desirable goods and services, thereby making them available to those on low incomes. For example, health care services, education, and infrastructure that includes sanitation and clean water supplies.
Transfer payments: payments by the government for which no goods or services are exchanges. For example, old age pensions, unemployment benefits and child allowances.
Relationship between equity and efficieny
Government intervention can put greater pressure on taxpayers and disincentivise workers. In order to avoid this, governments aim to keep taxes equitable so that they are based on the taxpayer’s ability to pay and to make taxes convient to pay by taking into account the timmings and methods. Also the cost of collecting tax should be small in comparison to the tax yield, otherwise it is no longer economical.