# Inflation - A2 Economics

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• Created on: 15-06-13 10:13

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Inflation
Inflation is commonly understood to be the percentage change in the general level of prices in
an economy over a period of time. RPI is a measure of inflation, calculating changes in the
level of prices paid by consumers over time.
How a price index number is calculated:
A same of products is taken
A starting point is defined ­ a base date or rate
The price of these products at the base date is found, each represented by the
number 100
At a later date, the prices are found again, and the new price is expressed as a
percentage of the price at the base rate/date. A price index for each product is
calculated.
An average of the price indices is found to give an overall average index.
The rate of inflation can be found by comparing the new index with the value of 100 at
the base date/rate.
Product Original price Index New price Index
Crisps 20p 100 25p 125
Petrol 50p 100 70p 140
Trainers £40 100 £42 105
Lager £1.20 100 £1.80 150
Total 630
Average 126
The new index can be calculated by:
In this case, the rate of inflation since the base date has been 26% (the last two digits of the
index).
The need for weighting
The result gained above is misleading if the intention is to gain an idea of changes in the cost
of living. Some items are more important in people's spending than others. There is a need to
weight the items according to the percentage of income spent on products.
Product Original New price Index % of income Index x weight
price
Crisps 20p 25p 125 10 1250
Petrol 50p 70p 140 40 5600
Trainers £40 £42 105 15 1575
Bread 40p 44p 110 5 550

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Lager £1.20 £1.80 150 30 4500
Total 630 100 134.75
Average 126 134.75
The index for each product is multiplied by the percentage of income spent on it. The price
change for petrol is four times as important as the price change of crisps. The total is divided
not by 5, but by 100.
The weighted index of 134.75 is higher than the unweighted index of 126, giving an inflation of
34.75% since the base date.…read more

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A host of other index numbers can be calculated. In order to predict movements in the RPI
sometime in the future, it is worth looking at:
The Producer Price Index ­ this shows changes in the prices of raw materials bought
by firms. If these increase, they will affect retail prices before long.
Index of Import Prices ­ if imports go up in price, this will increase costs of
production, and eventually, retail prices.…read more

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As AD increases, at first, the economy is able to meet the extra demand placed upon it, but
as full employment is approached, demandpull inflation starts to be caused. Once full
employment is reached, the effect of any increase in demand is purely inflationary. The
inflationary gap is the distance between the existing AD curve and the level of AD needed to

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A rise in the price of oil would lead to higher petrol prices and higher transport
costs. All firms would see some rise in costs. As the most important
commodity, higher oil prices often lead to cost push inflation.
2. Imported inflation
Devaluation will increase the domestic price of imports. Therefore, after
devaluation we often get an increase in inflation due to rising cost of imports.
3. Higher wages.
Wages are one of the main costs facing firms.…read more

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It is not always possible to distinguish between cause and effect (i.e. cause being
inflation, but inflation can be the effect too)
Issues with time lags i.e. by the time we identify it, it may be outdated.
The Quantity Theory of Money
Inflation may be defined as an increase in the general level of prices. In Britain, this is
measured by the changes in the CPI. Changes in the rate of inflation may be explained by
demandpull, costpush or by excess supply of money.…read more

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If V falls when the money supply (M) rises, or if more money is accompanied by more
goods to buy (more T), an increase in M need not lead to an increase in prices.
o How can P rise without an increase in M?
The price level will rise without an increase in the amount of money in
existence (i.e. inflation) when consumers purchase more goods and
services more than the nation can produce i.e. demandpull inflation.…read more

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The impact of QE on inflation is unclear. If we look at a more broad definition of money, the
effect on QE should be small (as one asset is swapped for a more liquid one). A more
narrow definition may give a different answer, as the process of QE has inflated M (as before
it contains notes, coins and current balances, any bonds were not included in its

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Money supply
Ways to combat inflation
1. Monetary Policy
Control growth of demand through interest rates. IR affects consumption, investment,
and exports. The wealth effect plays an important part with regards to consumption.
Control IR controls money supply, as it is the amount consumers pay for money. If IR
increased, the money supply would fall as consumers opt to save.
Cheaper to invest in businesses if IR falls ­ this may decrease costs of production

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Appreciation of the exchange rate
Appreciation makes UK exports more expensive (the pound is stronger, while other
currencies weaken).
Imports become cheaper, an increase in ER should appreciate the pound (assuming
IR is higher than competing countries). As we import a great deal, this should reduce
COP, which will help to keep business costs low, therefore SRAS increases, bringing
prices down and increase in national income.…read more