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sustained increase in the general price level- value of money will decrease
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official measure of inflation, excludes mortgage interest payments
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RPI (retail price index)
includes mortgage interest payments- used to be official measure
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Inflation of 2010/11
caused by cost-push factors such as higher taxes, effect of devaluation and rising commodity prices
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costs of inflation- 1) Cost of reducing inflation
high inflation is unacceptable therefore governments feel they need to reduce it. This will mean higher interest rates; reduction in AD will lead to lower economic growth and unemployment
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2) International competitiveness
Higher UK inflation will make British goods less competitive, fall in exports- however this may be offset by a decline in the exchange rate
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3) Uncertainty
When inflation is high, people are uncertain, firms are less willing to invest because they are uncertain about future profits and costs. Leads to lower growth in the long term
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4) Menu Costs
Cost of chnaging the price list frequently
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5) Shoe leather
To save on losing interest in a bank, people will hold less cash and make more trips to the bank
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6) Income redistribution
Borrowers will become better off; lenders will become worse off
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7) Boom and Bust economic cycles
High inflationary growth is unsustainable and usually followed by a recession
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Money Supply define
Measure the amount of money in the economy
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THe level of notes and coins in circlation and bank operational balances at the Bank of England
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M0 also know as
Narrow money
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Notes and coind in circulation plus the private sector deposits in banks and building societies
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M4 also known as
Broad money
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Monetarist Theory on causes of inflation
Monetarists argue that if the Money Supply rises faster than the rate of growth of natoinal income then there will be inflation
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Quantity Theory of Money
MV=PY M= money supply, V=Velocity of circulation, P=price level, Y=National income
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Monetarists Belive
In the SR velocity is fixed, output (Y) is fixed by supply side factors. If there is a change in the money supply then Y will return to the LR equalibrium- The LRAS is inelastic in the Monetarist model
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Therefore, an increase in the Money supply (M) faster than growth or national income will lead to
an increase in inflation (P)
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Explain how the graph works for the monetarist theory of money
A rise in MS consumers have more money so spend more, shoft out AD, firms respond by increasing output along SRAS causing inflation to rise. Firms need to hire workers so wages rise leading to increase in costs and hence prices- SRAS shifts to left
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As prices rise, money can buy less, therefore there is a movement to the left along the new AD until price level=P2. The economy has returned to original equalibrium level of output but at a higher price level
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Criticisms of Monetarism-1
Evidence in 1980s showed money supply could grow much faster than the price level suggesting link was not true
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Velocity of circulation V is not stable, but can change due to factors such as increase in the use of credit cards. Growth in the money supply can be erratic and due to institutional factors eg more cash machines caused an increase in M0
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Monetarists say that income can vary in the SR but the SR could be a long time and therefore make the policy ineffective. Keynesians argue that LRAS is not necessarily inelastic- they argue that economy can be below full capacity for a long time
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Keynesian Vuew (demand pull inflation)
If economy is close to or at full employment then an increase in AD leads to an increse in price level. An increase in AD will not always casue inflation if there is spare capacity in the economy
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Demand pull inflation can be caused by factors such as- 1 Loose Monetary Policy
If interst rates are too low then AD will increase faster than AS and economic growth will be unsustainable
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2- High consumer confidence and spending
If wages are increaseing and consumers are optimistic about the future then they will increase spending casuing AD to increase
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Cost push inflation is
if there is an increase in the costs of firms then the firms will pass this on to consumers- there is a shift to the left on the SRAS
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Cost push inflation can be casued by- 1 Wage push inflation
Trade unions can bargain for higher wages- leading to an increase in the costs for firms- may also cause demand pull inflation as consumers spend more
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2-Import Prices
One third of all goods are imported into the UK- if there is a devaluation then imported prices will become expensive leading to increase in inflation
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3-Raw material prices
If oil price increases by 20% then this will have a large impact on firms' cost and therfore inflation
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Evaluation of Inflation-1
The MPC was made independant in 1997- and are responsible for setting interest rates and attaining the Government's 2% target of inflation
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Between 1997 and 2007- Inflation remained low and economic growth positive
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There was a boom in bank lending and house prices during this time, In 2007 credit crunch led to a serious recession
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2009-2013, inflation was often above target due to cost push factors such as devalueation, rising oil prices and higher taxes- MPC couldn't have reduced inflation without causing a deeper recession and has been sucessful in keeping inflation low
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MPC introduced quantitive easing to boost money supply but had little effect in ending the recession
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Deflation Define
Occurs when there is a fall in prices; meaning a negative inflation rate (eg CPI =-0.5)
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Deflation casued by increased productivity
if significant increase in productivity eg better technology then LRAS will shift to right causing a fall in the price level and an increase in Real GDP. This is benficial for economy
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Deflation caused by falling AD
Lower AD has caused a fall in the price level but also caused a fall in Real GDP- this deflation can be very damaging to the economy
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Problems of deflation- 1 Lower spending
If prices are falling, consumers will be more reluctant to spend because they feel that prices will be lower in the future. This delay in spending will reduce AD and cause lower economic growth
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2-Liquiduty Trap
Monetary policy becomes ineffective becasue interest rates cannot fall below zero, meaning real interest rates will be too high
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3-Real wage unemployment
Workers are reluctant to accept a cut in nominal wages therefore firms may have to increase real wages by more than they would like. This could increase real wage unemployment
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4- Real value of debt will increase
This can reduce AD further as firms and consumers struggle to pay the increasing debt burden
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official measure of inflation, excludes mortgage interest payments

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RPI (retail price index)


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Inflation of 2010/11


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costs of inflation- 1) Cost of reducing inflation


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