ECON2: The National Economy 2.11 Inflation & Deflation If a basket of goods cost £1000 in 1990, at 2% inflation, what would it cost today? ECON2: The National Economy http://www.whatsthecost.com/cpi.aspx

The concepts of price inflation and deflation 2.11 What you need to know The concepts of price inflation and deflation The concepts of demand-pull and cost-inflation

Define the terms inflation and deflation 2.11 You should be able to: Define the terms inflation and deflation Understand the causes of inflation and deflation Explain the difference between demand-pull and cost-push inflation

Inflation: A Definition “The rate of change in the average price level over time.” OR The sustained increase in the cost of living / fall in the purchasing power of money http://www.bbc.co.uk/news/business-22122569 What does inflation mean for a family like yours?

Why does inflation matter? Over time, the price of goods and services tends to rise It is important to understand why this is the case, and what impacts this may have If wages and earnings remain constant, then as prices rise, consumers are worse off in real terms, as their disposable income will buy less goods and services than previously Therefore it is said that inflation erodes the value of money Inflation is a main focus of macroeconomic policy and the Bank of England has been delegated an inflation target of 2%

Two principle measures The Consumer Prices Index (CPI) Measuring Inflation Two principle measures The Consumer Prices Index (CPI) The Retail Prices Index (RPI) NB1: The preferred measure is the CPI, and this is the measure that forms the Bank of England Target. NB2: Both indexes are “weighted” Find out the difference between the CPI and RPI measures of inflation.

The Basket of Goods and Services (1) The Office of National Statistics (ONS) compile the CPI and RPI Both measures are based upon a basket of goods and services which is designed to represent typical purchases of consumers throughout the UK There are around 700 items in the basket of goods and services Different items are weighted according to their relative importance in terms of how much their price changes impact upon consumers For example, petrol is given a high weighting given that it forms a large part of individuals disposable income and there are few direct substitutes

The Basket of Goods and Services (2) What goods and services do you think make up the typical household basket?

The Basket of Goods and Services (3) The ONS update the “basket” every year to reflect changes in spending patterns “Constants” 1947 – The First Basket of Goods and Services Recent Additions Bread Sewing Machines Broadband subscriptions Milk Condensed Milk Smart phones Eggs Mutton Online gaming Petrol Unskinned Wild Rabbits Blu-Ray Discs School uniforms Lamp Oil Music Downloads Gas + Electricity Bills Gramophone Records E-Books

Causes of Inflation There are 2 primary causes of inflation Demand-Pull Cost-Push http://www.bbc.co.uk/news/business-23324635 http://www.bbc.co.uk/news/business-23678274 What factors are affecting inflation in the UK?

Demand-Pull Inflation Demand-pull inflation is caused by excessive demand in the economy for goods and services there is too much money chasing too few goods and services The best way to think about this is using the AD formula: C + I + G + (X-M) Remember, consumption is the largest component of AD, although any stimulant to AD will create some demand-pull inflationary pressure if supply remains unchanged

Causes of Demand-Pull Inflation Reduced taxation Increases disposable income Lower interest rates Makes borrowing more attractive and saving less rewarding A general rise in consumer spending Perhaps from higher incomes and consumer confidence Improved availability of credit Banks/Building Societies widen the availability of credit or make it more affordable A weak exchange rate Will boost export growth Fast growth in other countries May increase demand for UK exports General rise in confidence / expectations of future growth May feed through to higher consumer spending and investment Certainty Links to confidence and assists consumers and firms in their spending and investment decisions

Demand-Pull Inflation Diagram 1) Begin with the equilibrium position. 2) If there is a cut in interest rates, this makes borrowing on credit more attractive, and saving less rewarding so consumption may rise. Price Level 3) This leads to a rise in AD to AD1. SRAS 4) In the short-run, factor resources remain unchanged and if demand for goods and services rises faster than firms are able to provide additional supply, then prices will be ‘pulled’ upwards to P1. P1 P AD1 AD Demand-Pull Inflation Diagram Y Y1 Real National Output

Cost-Push Inflation This occurs when firms respond to rising costs (of production) by increasing prices Firms will typically do this to protect profit margins That said, firms may be able to absorb some increases in their costs of production, but they will not be able to do this indefinitely, and so pass costs onto the consumer in the form of higher prices

Causes of Cost-Push Inflation Wage increases For many firms, wages is their largest single cost of production It is likely that if prices are rising, workers will demand higher wages in order to maintain their ‘real’ incomes If these higher wage costs are reflected in higher prices, then workers will continue to demand higher wages, leading to a wage-price spiral Higher raw material costs As primary raw materials become more scarce and in even greater demand, raw materials and associated components may rise in price Higher taxes The government may impose higher taxes on firms; for example, corporation tax, national insurance, or taxes on waste disposal Higher import prices A weaker exchange rate or rising prices abroad mean that imported components feed through to higher costs of production Natural disasters May temporarily or permanently reduce the supply of raw materials or disrupt the supply chain, adding to a firms costs

Cost-Push Inflation Diagram 2) If there is an increase in wage rates, this will increase a firms costs of production. 1) Begin with the equilibrium position. 3) This will reduce SRAS to SRAS1 because faced with higher costs of production, firms will reduce their supply, or may even leave the industry if they cannot maintain profit margins. Price Level SRAS1 SRAS P1 P 4) As a result, rising costs have “pushed” up prices to P1. AD Cost-Push Inflation Diagram Y1 Y Real National Output

Deflation Deflation is a decrease in the general price level This is not to be confused with a falling rate of inflation For example, if the rate of inflation changes from 2.7% to 2.3%, this DOES NOT mean prices are falling It means that prices are increasing at a slower rate For deflation to occur, the average level of prices must be falling http://www.bbc.co.uk/news/business-22726058 Read the article about deflation in Japan. Why is it happening? How might the Japanese authorities react?

Causes and Problems of Deflation Deflation tends to occur during periods of very low, or stagnant growth Despite the fact that the value of money would be rising, deflation generally indicates that demand is very low or suppressed As prices are falling, consumers tend to delay purchasing decisions because they think prices will fall in future As a result, consumption slows significantly Which is likely to mean that firms will lose the confidence to invest, thus harming aggregate demand still further

Can you explain your answer? Multiple Choice 1 All other things being equal, lower inflation in an economy is most likely to be achieved if there is an increase in productivity exports consumption welfare benefits Can you explain your answer? A

Multiple Choice 2 Price Level SRAS1 SRAS P1 P AD Real National Output The diagram represents an economy that has experienced inflation, with the price level rising from P to P1. The most likely cause of the inflationary pressures shown in the diagram is a sustained increase in bank lending a growing budget deficit money wages increasing faster than productivity a period of time when interest rates are too low Can you explain your answer? Price Level SRAS1 SRAS P1 C P AD Real National Output

Deflation is most likely to cause consumers to delay their purchases Multiple Choice 3 Deflation is most likely to cause consumers to delay their purchases lead to a rise in interest rates lead to a rise in imports reduce the real value of money that has been lent Can you explain your answer? A

The Consumer Prices Index (CPI) rises from 100 to 105. This shows that Multiple Choice 4 The Consumer Prices Index (CPI) rises from 100 to 105. This shows that The inflation rate has increased 5%. The average price level has increased by 5%. The price of every good has increased by 5%. Inflation in the economy is rising at a constant 5% per annum. Can you explain your answer? B

Define the terms inflation and deflation 2.11 You should be able to: Define the terms inflation and deflation Understand the causes of inflation and deflation Explain the difference between demand-pull and cost-push inflation