Inflation Learning outcome AC Define inflation SBC Economics Inflation Learning outcome AC Define inflation Explain how inflation is measured Describe the pattern of inflation in the UK in recent years Explain the causes of inflation and explain the processes with AS/AS curves Calculate using the Fisher formula (Quantity theory) Explain the effects of inflation Evaluate the various counter inflationary policies Reading: Units 28 and 89

A rise in the general price level Inflation A rise in the general price level

Inflation A fall in the general price level is described as deflation When inflation is very high it is described as hyper-inflation i.e. inflation of 2000% in Russia in 1992

Measuring inflation Measuring the change in prices is a difficult task Prices in the economy are represented by a ‘basket of goods’ The basket of goods contains goods and services that are commonly bought People find the prices of the goods and services over the country These prices are then used to calculate the average change in the price level

Measuring inflation In the UK inflation is measured using the retail price index (RPI) and the consumer price index (CPI) The RPI was the traditional index used to calculate inflation in the UK, it was however replaced with the CPI which was a common measure used in all EU countries There is one other measure known as the RPIX; this is the same as the RPI except that it excludes mortgage interest payments

Causes of inflation There are three main causes of inflation: Demand-pull inflation Cost-push inflation Growth in the money supply

Demand-pull inflation Demand-pull inflation is caused by increases in aggregate demand (outward shifts of the AD curve) As AD shifts outwards firms will increase output and increase their prices The extent of the increase in prices depends on the shape of the AS curve Persistent demand-pull inflation is caused by continuous outward shifts in AD as may be seen during a boom

Demand-pull inflation Price level AS P2 Q2 P1 AD2 AD1 O Q1 National output

Cost-push inflation Cost-push inflation is caused by decreases in aggregate supply (inward shifts of the AS curve) As firms face an increase in costs they will decrease output and increase their prices The extent of the increase in prices depends on the shape of the AD curve Persistent cost-push inflation is caused by continuous inward shifts in AS as may be seen when wages are consistently rising

Cost-push inflation AS2 AS1 AD Price level P2 Q2 P1 O Q1 National output

Growth in the money supply The Quantity theory of money (Fisher formula) states that: MV=PT Where: M = money supply V = velocity of circulation P = price level T = number of transactions

Growth in the money supply Using the Fisher formula it can be seen that if there is an increase in the money supply (M) the result will be an increase in the price level (P) The rise in the price level is inflation caused by growth in the money supply Moderate growth in the money supply is acceptable, however excessive growth in the money supply will cause inflationary problems

Inflation Inflation is generally considered to be a problem, the higher the rate the greater the problem There are a number of costs of inflation, namely: Shoe leather costs Menu costs Psychological costs Redistribution of income Unemployment and growth Investment Trade Lending and saving

Costs of inflation Shoe leather costs When inflation is low consumers and firms know what the market price is When inflation is higher consumers will have less idea of the market price and will search around for the lowest price, the time spent doing this is a cost When inflation is high consumers will prefer to keep their money in the bank rather than in cash, they have to go to the bank more often when they need money, the time spent doing this is a cost

Costs of inflation Menu costs When there is inflation firms will have to change their prices Restaurants will have to print new menus Shops will have to change their price labels Firms will need to alter vending machines and parking meters

Costs of inflation Psychological When there is inflation people see prices increasing, they feel as if they are worse off (even if their incomes are increasing) Redistribution of income Inflation reduces the value of money People earning a fixed income will see the value of their income reduced It will reduce the value of money saved in the bank If tax allowances and tax bands are not changed people will pay a higher % of their income in tax

Costs of inflation Unemployment and growth Inflation increases the costs of production and creates uncertainty This lowers the level of investment Investment Lower investment results in lower economic growth and creates unemployment

Costs of inflation Trade If inflation is greater than in other countries and the value of the currency does not change then exports will become less competitive and imports more competitive The result is a worsening of the trade balance Lending and saving Inflation erodes the value of money and therefore people that save will be worse off and those that borrow will be better off

Counter inflationary policies Inflation can be controlled using: Monetary policy Fiscal policy Exchange rate policy

Monetary policy Monetary policy can effect aggregate demand If the government (or central bank) use deflationary monetary policy then AD will shift inwards and there will be a decrease in the price level (lower inflation) Examples: raise the interest rate, reduce the money supply, restrict the availability of credit

Fiscal policy Fiscal policy can effect aggregate demand If the government use deflationary fiscal policy then AD will shift inwards and there will be a decrease in the price level (lower inflation) Examples: cut government spending, increase the tax rate

Exchange rate policy Exchange rates can be used to control inflation; it works in two ways: Firstly, a higher exchange rate (stronger currency) will make imports relatively cheaper thus reducing the price level Secondly, a higher exchange rate (stronger currency) will lead to a fall in exports and a rise in imports (X↓ M↑) this will lead to a decrease in aggregate demand and the AD curve will shift inwards

Deflationary policy AS AD1 AD2 Price level P1 P2 O Q2 Q1 Monetary policy, fiscal policy or exchange rate policy can be used to shift the AD curve inwards and therefore reduce the rate of inflation Price level AS P1 P2 AD1 AD2 O Q2 Q1 National output