1. Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1 Lesson 8:  Inflation  Impact of inflation on economic behaviour  Measures of inflation 8cis

2. What is Inflation?  Inflation is the rate of rise in the average price level or a fall in the value of money  Deflation is a sustained fall in the average price level Inflation used to be a major problem in UK in the 1970s. If you had bought a Mars Bar for the equivalent of 75p at the beginning of 1975, by 1980 you would have paid 142p – an increase of nearly 90%. UK inflation (CPI) 1975 - 2007

3. How is Inflation measured?  The Consumer Price Index (CPI) is the main measure of inflation for the UK  Retail Price Index (RPI) – includes mortgage repayments and housing costs The CPI is measured by taking a large number of prices of goods and services used by ordinary people, working out how much each price has changed and then weighting the price changes according to their importance. Some price changes have a much bigger impact on people than others:  An increase of 5% in the price of bread is likely to affect people much more than a 100% increase in the price of matches.  Bread therefore gets a much bigger weighting than matches, and changes in the price of food will have a bigger effect on the CPI.

4. Other inflation measures  Harmonised Index of Consumer Prices (HICP) – a standardised measure used throughout the EU  RPIX – the RPI excluding mortgage interest payments The RPIX is often referred to as the “underlying “ rate of inflation. By excluding mortgage interest payments, it removes much of the impact of interest rate changes in general from the measure of inflation The EU prefers to use Consumer Price indices because a large proportion of people in Continental Europe rent their homes rather than buy them. The CPI excludes other housing costs in addition to mortgage interest, such as the cost of maintaining a home in a constant condition. Home ownership in EU

5. Annual inflation rates - 12 month percentage change Source: UK National Statistics Different indices tell different stories

6. UK interest rates and inflation 1999- 2007 What causes inflation? There are several possible causes of inflation:  Excess demand in the economy  Scarcity of resources or key workers  Rapidly increasing government spending The main weapon used by the government to control inflation is interest rates:

7. Inflation: who pays? Inflation will not only affect individuals, but will also cause problems for the whole economy. The costs of inflation include:  Uncertainty - if inflation keeps varying, then firms may be reluctant to invest in new plant and equipment as they may be unsure of what the government will do in the future. The real value of future pensions and investment income becomes difficult to assess, which might act as a disincentive to save.  Income redistribution - many people have to live off fixed incomes, particularly those on pensions: the higher the level of inflation, the less their income will be worth. This also affects employees, as their wages or salaries usually do not rise as fast as inflation.

8. Inflation: who pays? Other costs of inflation include:  Menu costs - this is a general term for all the inconvenient costs that businesses and individuals face. As prices increase they have to redo their price lists, change price labels, reprint menus and so on. If inflation is constant these costs can mount up.  Competitiveness - if our prices are increasing faster than those in other countries, then our goods will be less competitive and less in demand. This will have a negative effect on the balance of payments.

9. Inflation: are there any positives? There are some positive aspects to high levels of inflation:  Wealth effect: rising house prices contribute to a “feel good” factor (though this might contribute to further inflation as house owners become more eager to borrow and spend)  Borrowers benefit: the value of the borrower’s debt falls in “real terms” – i.e. after adjusting for the effect of inflation

10. What causes Inflation? Demand PullCost Push Where there is excess demand Where costs rise

11. Demand-pull inflation Demand-pull inflation will therefore usually occur along with a booming economy. To avoid demand-pull inflation you need to try to keep the economy growing at a steady, but not excessive rate - a tall order! One of the principal causes of inflation is excessive demand - 'too much money chasing too few goods'. If demand is growing faster than the level of supply, then prices will increase. Output will increase as well, as there is a shift along the aggregate supply curve, but because supply cannot keep up with demand prices go up as well. This is shown in the diagram below:

12. Cost-push inflation Wage increases - wages are a major proportion of costs for many firms and so if wages are increasing, this may well cause cost-push inflation. Government - if the government changes taxes, this may push up firms' costs. This is particularly true with excise duties on fuel and oil. Changes in interest rates can also affect firms’ costs if they have borrowed significant amounts. Abroad - exchange rate changes can affect firms' costs, particularly if they import many of their raw materials. An exchange rate depreciation will increase import prices and may therefore increase firms’ costs. Cost-push inflation happens when firms' costs go up. To maintain their profit margins, firms then need to put their prices up. In other words cost increases have pushed inflation up. Cost-push inflation may arise from various sources: The effect of cost increases is to shift the aggregate supply to the left. As we can see from the diagram above, this pushes up prices.

13. Advantages of Inflation for a business  Industry -wide price rises enable revenue to grow  Real assets are worth more  Makes using debt as a source of finance cheaper in real terms Disadvantages of Inflation for a business  Can damage profitability eg for fixed price contracts  Price of new assets increase  Less competitive prices in international markets  Increasing costs  Wage-price spiral

14. Government objectives for Inflation  The government has set the Bank of England a target for inflation of 2% (CPI)  The aim of this target is to achieve a sustained period of low and stable inflation  Low inflation is also known as price stability

15. Bank of England and Inflation  Interest rates are used by the Bank of England as a key weapon to control inflation and prevent deflation  The Bank of England base rate fell sharply to 0.5% in 2008 as fears of deflation and a prolonged recession grew stronger

16. Video http://news.bbc.co.uk/1/hi/business/7960816.stm Questions  What is the difference between the components of CPI and RPI?  Why has the rate of inflation been going down?  What are the fears about deflation for the economy?

17. Deflation describes a period in the economy when.. 1.The average level of prices is falling 2.Economic growth is rising 3.The value of the exchange rate is uinchanged 4.The rate of growth in prices is falling MULTIPLE CHOICE – CHOOSE ONE

18. Price increases may lead to higher wage demands as people try to maintain their living standard. This is known as... 1.Index linking approach 2.Wage-price spiral 3.Deflationary cycle 4.Hyperinflation problem MULTIPLE CHOICE – CHOOSE ONE

19. Which one of the following could be a cause of demand-pull inflation? 1.An increase in interest rates 2.An increase in the level of consumer spending 3.Higher import costs from a weaker pound 4.An increase in the cost of labour MULTIPLE CHOICE – CHOOSE ONE

20. What is the UK government’s target rate of inflation? 1.It no longer has an official target 2.Zero per cent 3.Two per cent 4.Five per cent MULTIPLE CHOICE – CHOOSE ONE

21. Identify a reason why inflation could be helpful to businesses… 1.Consumers feel their living standards are higher 2.Debt becomes cheaper in real terms 3.Competitors find it harder to gain market share 4.Employees can earn higher bonuses MULTIPLE CHOICE – CHOOSE ONE

22. Which one of the following would not be possible cause of cost-push inflation? 1.A weaker exchange rate 2.Commodity price increases 3.Sudden increase in supply of raw materials 4.Growth in factory wages MULTIPLE CHOICE – CHOOSE ONE

23. Low inflation is also known as... 1.Price stability 2.Price control 3.Price deflation 4.Price convergence MULTIPLE CHOICE – CHOOSE ONE

24. If a consumer price index rises, it shows that... 1.The value of currency has increased 2.On average, prices of consumer products are rising 3.All prices in the economy have risen 4.The economy is definitely growing MULTIPLE CHOICE – CHOOSE ONE