4.5 Inflation Understand what is meant by price stability, inflations and the rate of inflation. Understand how inflation is measured. Identify and explain the causes of inflation.

Inflation Def – is a sustained rise in the general price level over time. If price level rises then consumers money does not go as far- therefore we could say inflation is a fall in the value of money. Living costs go up. Although we talk about price of goods going up, it does not relate to all goods.

Price Stability Here the general level of prices is kept constant or grows at an acceptable rate. We do not want zero inflation, in fact the government would set a target of 2%.

Rate of Inflation This looks at inflation based over a period of time. This is usually expressed as an annual rate.

How is inflation measured? The most prominent and official (for UK Government and other EU countries) measure is the CPI – Consumer Price Index. Takes the spending pattern of the average UK family and records the prices of those goods in numerous different outlets across the UK. The goods are weighted- i.e some goods have more of an impact on inflation. Index given the number 100 and should it go to 103, then inflation is up 3% overall.

Must note that although the official rate of inflation may rise, because we are dealing with the average goods for average family, in real terms for others they may find inflation has gone up higher or even remained static.

Why measure inflation? SO the question maybe asked then, if inflation may not affect everyone why measure it? Answers; 1. Inflation is used in discussions for pay rises, particularly with Union bosses. 2. For certain companies (Possibly BT) they are allowed to increase their prices by the rate of inflation minus 2 % 3. Pensions are linked to inflation.

Causes of inflation 1. Demand Pull Inflation. Here inflation is caused by excess demand in the economy. The supply can not match this and so the price of the goods goes up. E.g 100 people want and are able to buy 80 TV’s. Demand pull inflation usually happens when employment is near full. Some economists believe in ‘Monetary inflation’ which states that demand cant rise unless there is an increase in the economy’s money supply. IMP if too much demand we must consider ‘scarcity of resources’. Resources are only scarce as long as people want them.

Cost-Push Inflation Price goes up because cost goes up. This can be because business’ want higher profits or because cost of production goes up because the suppliers want more profit. EG selling pens for £1.00, the price need to go up if cost of ink increases, i.e the raw materials increase. Further we can look at the exchange rate

If we buy ink from USA costing $2 and exchange rate is £1 = $2 – we will be paying £1. However if exchange rate changes to £1 - $1 then we will have to pay £2 for ink.

Wage- price Spiral This is all down to expectations. People expect inflation to rise so request a higher wage but because wages go up, then prices go up which means that wages may need to increase again etc.. Conservatives had a high risk strategy in 1990’s called MTFS (medium term financial strategy) where they predicted how the rate of inflation would rise over the medium term. This had an effect of dampening down expectations so that it wouldn’t spiral. FYI 0-2 YEARS = SHORT TERM 2-5 YEARS = MEDIUM TERM 5+ = LONG TERM.