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S15
IGCSE®/O Level Economics
6.1 Price inflation
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What is inflation?
Inflation is a general and sustained rise in
the level of prices of goods and services
i.e. prices of the vast majority of goods and
services keep on rising
Some countries have experienced
hyperinflation in the past: runaway
inflation during which prices rise at
phenomenal rates and money becomes
almost worthless
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How to measure inflation
There are many millions of different goods and
services exchanged in an economy, so most
countries track the prices of a selection of goods
and services to construct a price index
Year 0 (base year)
•
Identify the basket of goods and services
purchased by the ‘typical’ family
•
Monitor the ‘average’ price of each item in the
basket at a sample of different retail outlets
•
Monitor how much the ‘typical’ family spends
on each item in the basket
•
Weight the average price of each item by the
proportion of household expenditure spent on it
•
Add up all the weighted average prices
•
Set the total weighted average price of the
basket equal to 100
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Year 1 onwards
•
Repeat the monitoring of household spending
patterns and prices
•
Compare the total weighted average price of the
basket to base year to calculate the change in
the price index
Calculating a consumer price index
Price of basket was $25 in base year, so annual inflation has been 8%, i.e.
Note: The basket of goods and services bought and the weights applied to each item in
the basket may change from year to year as products and spending patterns change
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RPI or CPI?
Most countries compile a
consumer price index
(CPI) or a retail price
index (RPI), or both
The methodology used for
each index series is the
same, but the products they
include and the types of
consumer they cover can
differ. As a result they can
provide slightly different
measures of inflation
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Uses of price indices
As an economic indicator
A consumer or retail price index is a widely used measure of price inflation
and therefore a measure of changes in the cost of living
As a price deflator
Rising prices reduce the purchasing power of wages, profits, pensions,
savings, tax revenues, and a host of other economic variables of
importance to different groups of people and decision makers. A price index
is therefore used to calculate changes in their real values over time
For indexation
Indexation involves increasing certain payments and values, such as state
pensions and income tax thresholds, by the annual rate of increase in price
inflation in order to keep their real value constant
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What causes inflation?
Economists today tend to agree that the main cause of inflation is ‘too
much money chasing too few goods’
i.e. if the money supply increases at a faster rate than the aggregate supply
of goods and services then the general level of prices will rise
The money supply may expand to meet demand and cost pressures ►
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Demand-pull or cost-push inflation?
A demand-pull inflation is caused by aggregate demand rising faster than
the aggregate supply of goods and services
A cost-push inflation is caused by rising wages and other production costs.
Firms will raise their prices to cover these additional costs
A rise in import prices may cause an imported inflation. Import prices may
rise following a fall in the exchange rate of the importing country
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The costs of inflation
Low and stable price inflation can be beneficial for an economy:
 It encourages consumers to buy goods and services sooner rather than later
 It reduces the real cost of loan repayments
But high or rising inflation can be bad for an economy:
x Inflation erodes the value or purchasing power of money. People, especially those on
low and fixed incomes, cannot buy as much as they did before with their incomes.
Demand for many products will fall if real incomes continue to be squeezed
x It increases the costs of production and reduces profits margins
x It reduces the price competitiveness of exports
x It creates economic uncertainty. Consumers, firms and governments will be uncertain
about their future costs and the impact rising inflation could have on their incomes and
revenues. Firms may cut their investment and consumers their spending
Stagflation: an economic situation when unemployment and inflation are both high and/or rising
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What is deflation?
▼ Japanese inflation, 1970–2010 (% annual change in CPI)
Disinflation refers to a slowdown in the rate
at which prices are rising in general
but
deflation involves a continuous decline in
the general level of prices in an economy
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So what’s so bad about falling prices?
Increasing supply, competition, productivity and technological advance are good things for
an economy and consumers, and have reduced the prices of many products over time,
such as mobile phones, televisions, cars, holidays and clothing, in many countries
However, when falling product prices become widespread and prolonged due to a slump
in aggregate demand, the result is malign deflation
In addition, the real cost of borrowing
and public spending rises. Firms cut
investment and the government must
cut spending or raise taxes.
Consumers delay
spending waiting for
prices to fall further
Stocks of unsold goods
accumulate so firms cut
their prices. Profits fall
Household incomes fall as
unemployment rises,
reducing demand further
Firms cut their production
and reduce the size of
their workforces
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Eventually the economy goes into a
deep recession as demand, output,
the demand for labour, and incomes
continue to fall. Many firms may go
out of business because they are
unable to make any profit no matter
how much they cut their prices.