A sustained rise in the general price level.
· Has to be general/average price level as some prices may rise and some fall.
· A fall in the value of money – wages become less valuable.
· Basket of goods > 700 products > each product is given a weight > most commonly bought is the heaviest > monitor price changes 120,000 prices > weight x price change > done by a weighted price index.
· Weighted price index:
To calculate the average price rise you need weightings – what people spend money on, found out by using the family expenditure survey (basket of goods).
What happens to prices over that period.
Multiply weights by price changes.
Types of Inflation
· Creeping – less than 10% p.a.
· Severe – 10-100% p.a.
· Galloping – 100-1000% p.a. e.g. Zimbabwe 2007.
· Deflation – prices falling e.g. Japan.
Causes of Inflation
· Cost push inflation:
Increases in cost of production leads to an increase in the price of a product.
Most important cost of production for most firms is wages.
· Demand pull inflation:
The demand for goods and services pulls the prices up.
Increase in demand leads to an increase in prices.
· Mixture of the two: wage price spiral.
· Too much money chasing too few goods: Monetary theory.
· Expectational inflation.
Controlling inflation is important because low and stable inflation is believed to be a key requirement for creating the right conditions for growth in an economy.
Anticipated inflation (stable, predictable, steady): the actual rise in general price level is close to what is expected.
Unanticipated (larger than expected jump): actual rise in inflation is higher than expected – more damaging than anticipated because it increases uncertainty.
Costs of Inflation
· Uncertainty: low confidence
Firms: if firms are uncertain about the future they might react by making redundancies
Consumers: worry that further unanticipated inflation may reduce the value of their income and savings > respond by reducing their consumption in order to save and create a buffer > falling demand leads to lower output and unemployment.
· International competitiveness: less of it
As UK price level rises relative to that in other countries, demand for exports falls whilst the demand for imports rises.
Leads to a fall in UK competitiveness.
This effect may well be offset by a fall in exchange rate – which may cause further inflation as the price of imports rises.
· Fiscal drag:
If money wages rise with inflation but tax bands do not, proportion of income taken in tax will rise, consequently the economy will slow down.
Confusion in the price mechanism:
difficult to distinguish whether a price rise is due to general inflation of is a genuine increase relative to other goods.
Producers and consumers may make the wrong interpretation and decisions.
· The cure depends on the cause/type.
· Fiscal policy – government expenditure and taxation.
reduced demands for goods and services by increasing taxes on income>less disposable income = less spending
reduce the government expenditure>govt. is the biggest spender in the UK>£587 billion in 2007/8
· Monetary policy – cost and supply of money
MPC at BoE increases interest rates>target 2%>increase in IR leads to increased saving, reduced consumption, reduced borrowing, increased mortgage repayments.
· Supply side policy:
increasing the amount of goods and service available
increasing incentives to work
Increasing incentives to produce
increasing entrepreneurship and risk-taking
· Wage restraint – anti TU legislation
· Reduce inflation expectations