IGCSE Economics: Inflation

IGCSE Economics: Inflation

Price Stability:

What is it?

• Inflation – A sustained increase in general (average) price level in an economy as measured over a period of months or years.
• Inflation is measured using the CPI (Consumer Price Index).
• This is used to capture the average price level in an economy.
• Inflation refers to a general and sustained rise in the level of prices of goods and services – price of vast majority of goods and services on sale to consumers just keep on rising and rising.
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• Price change over time (inflation) is always given per period of time.
• Hyperinflation is when prices rise at phenomenal rates in short periods of time, rendering money worthless.
• Deflation is when the prices of goods and consumer goods fall.
• Deflation can be a cause for concern – deflation will usually occur when demand for goods and services are falling, causing firms to lose profits, profits and reduce workforce.
• This will reduce household incomes, causing further reduction in goods and services.

  The value of debts held by people and firms will rise in real terms as prices fall and burden of making loan repayments rises.

• Eventually economy goes into recession.
• It is very normal:
• An inflation rate of approximately 3% is considered tolerable.
• The government aims to keep inflation rates as low as possible.
• Thus keep prices as stable as possible.
• Real income/interest increase = Nominal income/interest increase – Inflation rate.
• All of these increases or rates are percentages.
• The EU Government’s inflation target is 2% for the Consumer Price Index (CPI):
• The Monetary Policy Committee (MPC) in the UK sets interest rates at a level which it believes will meet said target over a two year forecast.
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• In Hong Kong the Monetary Authority’s task is to keep inflation as low as possible in Hong Kong.
• Governments generally want inflation to be below 5% and nowhere near the double-digit range.
• When inflation rates are high we buy less because prices are high.

How is inflation measured?

• It is measured monthly by the ONS (Office of National Statistics) which collects about 120 000 prices every month for a ‘basket’ of goods.
• This ‘basket’ includes approximately 650 different goods and services.
• The price of these items is compared to a base year in order to determine whether prices have risen or fallen since that base year.
• Each good or service is assigned a different weight according to its importance in our weekly shopping:
• For instance food has a large weight.
• Goods such as butter have had their weights decreased but olive oil has had its weight increased because people are becoming more health conscious.
• Cigarette weighting has decreased because of smoking bans.
• CDs have been removed altogether from the ‘basket’ and replaced with downloadable media because more people download media from the internet rather than buy them in the form of CDs.
• The video tape has been removed from the basket because the video tape player is no longer commonly available.
• Weightings can change over the course of the year.
• Different nations have different goods in their baskets because different things are demanded by the people in different nations.

CPI/RPI:

• The rate of price inflation in an economy is measured by calculating average percentage change in prices of all goods and services, from one point in time to another – usually monthly and year on year.
• It is difficult to track all goods and services sold in economy; hence goods and services monitored will normally be those purchased by typical households.
• The prices of this typical ‘basket’ of goods and services will be monitored at a selection of retail outlets across the economy, including online retailers nowadays.
• This information is compiled into a consumer price index (CPI) or retail price index (RPI).
• The CPI or RPI is used as main measure of price inflation affecting consumers in an economy, and is often considered to provide a cost-of-living index.
• A CPI/RPI will usually include sales taxes and excise taxes paid by consumers on their purchases, but exclude changes to income taxes and prices of assets such as stocks, shares, life insurance and homes.
• Prices of oil, electricity, gas and food are often excluded from CPI as their prices are highly volatile, due to short-lived shortages that can be caused by weather, droughts and severe winters, or OPEC cutbacks in oil production. They can therefore distort measures of more ‘usual’ price inflation.

Calculating the CPI/RPI:

• Indices express change in prices of a number of different products as a movement in a single number.
• Average of ‘basket’ of products in first year calculation or base year is given the number 100.
• If on average the basket rises overall by 25% next year, then index becomes 125.
• If in second year it rises another 10%, then 125 x 1.1 = 137.5 – 37.5 becomes average price rise in two year period.
• To construct a CPI, a sample of households are taken and surveyed – their spending patterns observed for 12 months which is the base year. The proportion of income spent on each category is recorded.
• Average prices of different goods and services (minus fuel and food) are recorded from a sample of shops.
• The proportion of income spent on each category is used to weight average prices of each type of good/service to find their weighted average prices.
• This shows how big an impact a change in price of a particular type of good or service will have on cost of living for the average household.
• The proportional of household income spent on a certain type of good/service is multiplied by the average price of the good/service purchased in the category, to generate its weighted average price – these weighted prices are then all added together, which is the overall average price for goods and services in the basket.
• The weighted total price of the basket can be compared each year to work out percentage changes in average consumer prices.

Uses of CPI/RPI Data:

1. As economic indicator – CPI is widely used measure of price inflation, and therefore is measure of changes in cost of living. Governments try to control inflation using macro-economic policies. The CPI will be used by workers to seek wage increases, and used by entrepreneurs in business making concerning purchases and setting wage and prices.
2. As a price deflator – Rising prices reduce purchasing power, value, of money. Rising prices can therefore affect real value of wages, profits, pensions, savings, interest payments, tax revenues and other economic variables important to people and decision making. CPI therefore used to deflate other economic series to calculate real inflation-free values. i.e. wages go up 10% but inflation is 15%, therefore real wages fallen by almost 5% less.
3. Indexation – involves tying certain payments to rate of increase in CPI. E.g. pensions may be indexed. Similarly, savings may be index-linked, meaning interest rate is set equal to CPI, protecting real value of people’s savings. Many workers may also be covered by collective bargaining agreements that tie wage increases to CPI changes. Government may also index threshold at which people start to pay tax or higher tax rates to stop people paying more or less tax.

Problems with Price Indices:

• Over time typical household basket of goods and services will change.
• CPI needs to take account of this, but deciding how and when to make them can be difficult.
• Changes due to:
• Fashion and taste
• Introduction of new goods and services
• Change in population and household size due to migration, birth/death rates, marriage timing and numbers etc.
• Similarly CPI needs to take into account changes in quality of goods and services over time, how and where households buy goods and services such as internet and new shops.
• International comparisons of CPIs are hard to make due to different household compositions and spending patterns.
• Argued that exclusion of food, energy, house prices and income taxes means CPI cannot accurately measure change of living cost.

Differences between the CPI (Consumer Price Index) and RPI (Retail Price Index):

• Historical record:
• The RPI was first used in 1947.
• The CPI was first used in 1980.
• Structure and classification:
• For RPI:
• The most important things are:
• Housing.
• Including mortgages, rents, etc.
• Travel and leisure.
• Education is not included:
• Most people in the past relied on state benefits (free education).
• For CPI:
• The most important things are:
• Transport:
• We commute (travel) to work more.
• Oil prices change very quickly nowadays and are very important because they affect the prices of many goods and services:
• You can measure changes in oil prices very easily by measuring changes in the price of transportation:
• This is speculation.
• Restaurants and hotels.
• Health and recreation are not highly weighted because most (average) families rely on state benefits.
• But recreation and culture have become more and more in demand in Hong Kong perhaps because of improving standards of living.
• All of the above may be true for some countries but may not be true for other countries.
• Housing is not included in CPI because it can often cause inflation figures to be much higher than what is really the case.
• International compatibility:
• RPI is mainly used in the United Kingdom.
• CPI is used internationally and conforms with what the European Union uses.

CPI:

• Does not include housing costs (cost of paying mortgages) unlike the RPI.
• The CPI only measures what the average household spends and does not offer much information on what above average or below average households may spend.
• The government chooses a basket of various goods (both essential and non-essential) from a variety of outlets:
• Transportation.
• Food and leisure.
• Education.
• The goods and services in the baskets can change over time as demands and trends change.
• These goods are weighted in accordance to their importance in the daily lives of the people of whatever nation the government belongs to.
• A rise in food prices affects people more than a rise in jewelry prices.
• Rice in China, being the staple food, would have greater weight than something like flour but in other nations where rice is not so important flour may have greater weight than rice.
• The price levels of these goods are then monitored.
• This is done because it is much more expedient than monitoring all the goods provided in an economy.
• RPI (Retail Price Index) is also used in Britain:
• Includes housing costs (cost of paying mortgages).

What are CPI figures used for?

• An economic indicator to show the changing costs of living.
• Remember any indicator termed as an index is out of 100.
• CPI of 105 = 5% inflation.
• CPI of 98 = -2% inflation = 2% deflation.

Who uses the CPI and RPI?

• CPI is used by:
• Governments to calculate state benefits and pensions.
• Businesses to calculate price levels.
• Society:
• To determine whether or not to demand a pay rise.
• To determine whether or not to save (are saving interest rates greater than the current inflation rate as indicated by the CPI?).
• RPI is used by:
• Pension companies to calculate indexed pensions.
• Governments to calculate state benefits which are usually index linked to the RPI.
• Savers to determine whether or not it is profitable to save (are saving interest rates greater than the current inflation rate as indicated by the RPI?).

Different types of inflation:

• Inflation rate of less than 4% is creeping inflation.
• Inflation rate of between 10 and 100% is strato-inflation.
• Inflation rate of greater than 100% is hyperinflation.
• Negative inflation rate is deflation.
• CPI is usually computed monthly.

Hyperinflation:

• Hyperinflation is defined as a sustained and rapid rise in the general level of prices for goods and services by a very large amount (usually at or more than 100% in a month).
• During periods of inflation:
• Money loses some of its value.
• During periods of hyperinflation:
• Money loses all its value.
• Money becomes worthless.
• During these periods barter trade is preferred:
• A physical item is more likely to keep its value than money is.

During Inflation:

• Every unit of currency buys less.
• It is better to pay loans and mortgages:
• Each unit of currency is worth less and even if the total amount of money that one must pay has increased due to interest, if this interest rate is less than the current inflation rate then the real value of the loan or mortgage has gone down.
• People save less:
• The interest they receive from doing so has less real value.

What is deflation?

• A sustained fall in general price levels as measured over a period of months or years.
• As things become cheaper:
• People stop spending as they expect prices to fall further in the future.
• “Wait and see” attitude is adopted by consumers.
• As such, firms start making less revenue.
• Firms start to produce less as less is demanded.
• Employers begin to hire fewer workers as they are no longer needed anymore.
• This causes the economy to eventually go bust.
• Linked to fall in aggregate demand:
• Linked to rises in unemployment rates.
• Linked to falls in wage rates as a result of falls in aggregate demand.

During Deflation:

• Every unit of currency buys more.
• Paying loans and mortgages becomes more bothersome:
• Each unit of currency is worth more which is compounded by the fact that the total amount to be paid has increased due to interest rate. Thus the real value of the loan or mortgage to be repaid has gone up.

Indexation:

• Tying certain payments to changes in the cost of living:
• When inflation rates rise, payment rates rise.
• Vice versa.

• Usually given:
• To students (scholarships).
• Or to pensioners (pensions).

Inflation Example:

Different types of inflation:

• In reality inflation is usually multi-causal.
• It is caused by multiple different reasons acting together.
• Monetary inflation.
• Demand-pull inflation.
• Cost-push inflation:
• This includes imported inflation.

Monetary Inflation:

• Too much money chasing too few goods:
• Supply of money grows faster than the supply of goods.
• As such consumers can increase the amount they spend faster than producers can increase the amount that they supply.
• Increased money is therefore being spent on a slightly larger amount of goods and services.
• Higher demand thus higher prices.
• There is a strong correlation between money supply and CPI.
• How does the money supply expand:
• Government issuing more notes and coins.
• Allowing banking system to create more credit or making credit (loans) cheaper with lower interest rates.
• Because when money is loaned more of it will be in circulation.
• Why will a government force the money supply to expand:
• Because they need to pay debts or to finance certain things or to stimulate economic growth:
• Germany, 1923, printed more money to pay strikers in the Ruhr(plunged into hyperinflation).
• Zimbabwe, recent, printed more money to finance its army and to stimulate economic growth (plunged into hyperinflation).
• Monetary Rule:
• Most governments will only allow the money supply to expand as fast as output in order to keep inflation stable.

Demand-pull inflation:

• Extra aggregate demand in an economy pulls up prices unless aggregate supply also rises to match this excess:
• This causes a rise in the general level of prices.
• Too much demand chasing too few goods.
• May be caused by increased government spending or by lower taxes:
• The latter causing people to have more disposable income (income after tax).
• Because of this there is a correlation between economic growth (when demand increases) and inflation.
• If the demand for apple products rises sharply and the supply is unable to match this rise then the price of said products will also rise.
• In such a case the government may choose to subsidize firms and so boost supply.

Cost-push inflation:

• Cost of production rises and so firms decrease output because of:
• Higher wage demands (rising labor costs).
• Prices of raw materials go up:
• Oil prices rise.
• Etc.
• It is caused by aggregate supply decreasing:
• Thus the supply curve shifts inwards.
• Firms pass these costs onto their customers in the form of higher prices:
• Leads to e.g. cost-price spiral:
• Increase in cost causing an increase in price which then keeps repeating.
• May also be caused by imports becoming more expensive:
• This is called imported inflation.
• E.g. price of oil increases.
• This is a big problem for countries without natural resources and who place great importance on these imports.
• Cathay Pacific is cutting flights to Europe:
• But many people have bought tickets!
• Thus Cathay shares flights with other airlines in the same alliance (One World).

Causes of Inflation:

• Economists today tend to agree main cause of inflation is ‘too much money chasing too few goods.’
• This means people are able to increase spending on goods and services faster than producers can supply goods and services, boosting aggregate demand and forcing prices up.
• A government can allow supply of money to increase in an economy by issuing more money or allowing banking system to create more credit – lending more to people and firms.
• A government may do so to :
• Increase total demand in economy to reduce unemployment.
• In response to increase in demand for goods and services for goods.
• In response to workers demand for higher wages, or rise in other production costs.
• As money supply rises, people’s purchasing powers rise and inflation can occur.
• To stop excessive inflation, a monetary rule government’s should follow is to only allow supply of money to expand at same rate as increase in real output or real GDP over time.
• If money supply increases faster than output, then inflation will occur.
• Stagflation – when inflation and unemployment are both high and increasing – often due to rising living costs causing increased demand for higher wages and less labour demand.
• Causes:
• Increase in Money Supply – an increase in money supply would increase the spending power of the average consumer, thus increasing demand and hence pushing up prices. This then causes inflation.
• Demand Pull Inflation – When aggregate demand is increased, firms are no longer able to meet demand in production and thus prices inflate. To finance this, firms may borrow more or money supply increased.
• Cost Pull Inflation – When the cost of producing goods is increased, firms may want to offset these increased costs to consumers to keep a certain level of profit, thus the extra cost is added to price of the good or service, causing inflation. Wage Price Spiral is when workers demand higher and higher wages, causing cost push inflation and prompting them to ask for higher wages again.
• Imported Inflation – rising prices in one country may be exported to another country through international trade in many different goods and services. Many countries have been able to enjoy stable inflation as China’s large supply of goods and services is produced through cheap labour.

Consequences of Inflation:

• Personal Costs:
• Reduce purchasing power
• Real income falls
• People like pensioners and students on fixed incomes will suffer from inflation.
• Low paid and non-unionized workers often fail to get sufficient rises to stop real income falling.
• Professional workers may ask for wage increases that protect or cause increases in real wage levels.
• Savers and lenders may be hurt by inflation rate if interest is less.
• People who borrowed may benefit.
• Demand-pull inflation increased spending can boost company profits, while cost-push may reduce profits. Rising profits could yield more tax, however government may have to pay more for goods and services.
• Economical Costs:
• Possible unemployment – purchasing power drops, less demand
• Some people save more, reducing economic activity and overall output
• Causes goods and services to become uncompetitive internationally
• Benefits:
• Economic growth
• Reduce debt values – falling value of money reduces real debt values
• Higher stock value
• Values of fixed assets could rise – financial security
• Possible increased employment
• Stimulate technological advancement