Inflation

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    An economy’s average (or general) price level is the average of all the prices in the economy. Inflation is a rise in the average price level over a given time period. Deflation is a fall in the average price level over a given time period.

    Demand-pull inflation occurs when AD rises, spare capacity falls, resources begin to run out so firms’ resource costs and prices rise

    Many costs of inflation exist:

    1) Transfer of Resources.

    Inflation causes a transfer of resources from savers to borrowers. Inflation devalues savings so savers are worse off. Inflation devalues debt so borrowers are better off.

    2) Interest Rates.

    If inflation is too high a tight monetary policy may be used to increase interest rates, so the cost of borrowing rises, consumers take out less loans and consumption falls.

    3) Investment.

    Inflation creates uncertainty, uncertainty means firms cannot plan, if firms cannot plan they cannot invest so investment falls. Also, if inflation is too high a tight monetary policy may be used to increase interest rates, so the cost of borrowing rises, investors take out less loans and investment falls.

    4) Menu Costs.

    As prices change, firms must change their prices and reprint menus and catalogues, edit websites and shop signs, this is costly for firms.

    5) Search Costs.

    As prices change, consumers incur search costs because they must keep up to date with all the new prices that firms charge.

    6) Wage-Price Spiral.

    As inflation occurs, workers cannot afford as much as before, workers demand higher money wages, firms’ costs rise, firms’ prices rise, workers demand higher money wages and the spiral continues. At the extreme, this could cause hyperinflation.

    7) International Competitiveness.

    A rise in country A’s prices means A becomes less internationally price competitive, A’s exports are dearer and fall, imports are cheaper so A imports more.

    Measuring Inflation A measure of inflation is the Consumer Price Index (CPI). An annual price survey, the Expenditure and Food Survey, is undertaken by the ONS to collect data. The CPI is a price index of a basket of roughly 700 goods and services typically bought by the average household. The basket includes food, drink, shelter, clothing, energy, education and banking services. Goods are weighted more if households spend more money on them.

    Each year the basket is updated to account for the changing patterns of consumer behaviour, some goods may be taken out and/or given less weight, current goods may be given more weight and/or new goods may be added. Limitations of the CPI:

    The sample may not be representative of the average household. For example, it could include too many rich households, so the basket will not represent the average household’s consumption. – Spending patterns may be dynamic and could change frequently throughout the year, meaning the basket and weights need to be changed more than once per year. – Black market transactions are unofficial, no data exists for them, so they cannot be included in the CPI. – Prices may rise over time because better quality goods are being sold (technically this is not defined as inflation).

     

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