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Unit 2 Managing the Economy-Measuring Inflation
What is inflation?
Inflation is a rise in the general price level in an economy sustained over time. General Price
level = average price level. `Sustained' means inflation is persistent.
What is deflation?
Deflation is the fall in the general price level in the economy, sustained over time.
What causes inflation?
"Too much money chasing too few goods" Milton Friedman. Inflation can be caused by an
increase in demand in the economy.
Cost-Push inflation happens when it becomes more expensive for firms to supply their
goods. It may be caused by an increase in raw materials. So firms' costs rise, so their prices
rise, so the average price rises.
Why is inflation a problem?
Inflation can be bad for savers because the value of money decreases with inflation
and the money that is saved cannot buy as much.
Inflation is GOOD because the value of their debt goes down so the money they
initially borrowed is worth less.
Inflation means higher interest rates, so this means the cost of borrowing rises.
If inflation increases then interest rates increase, cost of borrowing increases, firms
take out fewer loans and investments fall.
As inflation occurs prices rise so firms have to change their menus, websites, shop
signs etc. This costs time and money.
Consumers cannot afford as many goods and services so they demand higher wages,
so firms costs go up and their prices rise again.
How is inflation measured?
Inflation is measured by Consumer Price Index (CPI). CPI is compiled by the Office of National
Statistics (ONS). The ONS send researchers around the country every month to gather
prices of `basket' goods and services that are meant to represent the purchases of a typical
family. This is made up of 12 different components: food and drink, alcohol and tobacco,
clothing and footwear, housing and energy, furniture and household goods, health,
transport, communication, recreation, education, restaurants and hotels and miscellaneous
They check price levels of 650 goods and services that UK households purchase regularly.
The CPI is weighted-the price changes of goods and services that people spend their money
on are given more importance.
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The Bank of England's target on inflation is 2% +/- 1%.
How do you measure the weighting of CPI?
% = (new price-original price) x100
What are the limitations of the CPI measure?
1. Maybe too many rich households are included in the sample of 7,000 samples; this
will not represent the average household, vice versa.
2. Informal markets are where transactions are not officially recorded e.g. drug dealing,