Inflation “a sustained increase in the general price level” Household income : 10,000/yr Cost of Living: 10,000/yr Household income: 30,000/yr Cost of Living: 30,000/yr (focus on whole economy - not one particular industry – it’s possible for individual industry to experience decreasing prices when the economy is experiencing overall inflation)

Inflation Target - gov’t has set a target of 2% for inflation – this is deemed the best rate for a stable economy (higher than that and inflation can have negative effects; lower than that can mean a stagnant economy) As prices rise, the value of money falls – the same money can’t buy as much as it used to. The Bank of England is charged with the responsibility of controlling inflation through changes in the interest rate.

Measuring Inflation 1.Family Expenditure Survey – find out what households spend their money on (average basket of goods – approx. 600) 2.Weights Determined – goods that we spend a higher proportion of income on get more importance in the basket 3.Prices Checked – from stores across the UK 4.Weights Applied – price changes multiplied by the weight of that item 5.Total CPI – weighted price changes are totalled to give retail price inflation

Calculating CPI ProductWeightPrice Change Weighted Price Change Fuel10%X+ 20%=+ 2% Food25%X- 10%=- 2.5% Motoring5%X0%= Leisure20%X+ 5%=+ 1% Clothing10%X+ 6%=+ 0.6% Housing30%X+ 5%=+ 1.5% 100%Total CPI:+ 2.6%

CPI calculation exercise: Food: +2% Alcohol, tobacco: +6.1% Clothing: -0.5% Housing, utilities: +2.2% Furniture & household: 1.7% Health: +2.4% Transport: +2.5% Communication: +3.4% Recreation: +1.2% Education: +3.2% Restaurants, hotels: +3.0% Misc: +2.3%

Product Division% Price ChangeWeight in basketWeighted price change

Other Measures of Inflation RPI – slightly different contents of basket – importantly, includes mortgage interest (CPI does not include mortgage interest payments – this would overstate changes in interest rates made by the MPC) PPI – Producer Price Index – costs faced by producers (a leading indicator of RPI)

Cost-Push Inflation Firms respond to higher costs by increasing prices (AS shifts inward) AD AS AS 1 PL GDP Causes: ↑imported raw material costs ↑ labour costs ↑ indirect or direct taxes paid by firms

Demand-Pull Inflation AD grows faster than AS therefore prices are bid up by demand exceeding supply AD AS AD 1 PL GDP Causes: ↑ exports not matched by ↑ imports ↑ gov’t spending not matched by ↑ taxes ↓ interest rates → ↑ C ↑ wealth effect from ↑ house prices or stock market boom

Costs of Inflation Loss of competitiveness: ↓ exports due to high prices Uncertainty: ↓ investment Industrial unrest: workers may strike to ↑ wages Menu costs: constant changing of prices costs money (eg. reprinting menus)

Benefits of Inflation Reduces real cost of outstanding loans Allows for higher wages Decreased real cost of borrowing MAY increase investment