Inflation

Inflation and deflation

Inflation is a sustained rise in the general price level, so each pound buys less than it did. Money loses purchasing power.

Disinflation catches students out. If inflation falls from 6% to 3%, prices are still going up, just less quickly. Prices only fall when inflation is negative.

Most governments aim for low and stable inflation, usually around 2%, rather than zero, because falling prices bring problems of their own.

How inflation is measured

The Consumer Price Index (CPI):

1. A survey finds out what a typical household spends its money on.
2. A basket of several hundred common goods and services is chosen to represent that spending.
3. Each item is given a weight according to how much of the household budget it takes. Petrol has a much bigger weight than postage stamps.
4. Prices are collected each month and compared with a base year, giving an index number.
5. The inflation rate is the percentage change in that index over twelve months.

The weighting is the key idea: a 10% rise in the price of housing affects the index far more than a 10% rise in the price of something people rarely buy.

Problems with the CPI:

• It shows an average. Households buying different things face different inflation rates, a family spending a lot on energy suffers more when energy prices spike.
• The basket is only updated once a year, so it lags behind changing habits.
• It struggles to allow for improvements in quality, a phone costing the same as last year but doing far more is effectively cheaper.
• It does not cover the informal economy.
• Errors can creep in from sampling and from collecting prices in only some shops.

Causes of inflation

Demand-pull inflation, too much demand chasing too few goods.

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1. Consumers, firms or the government spend more
2. but the economy cannot produce any more, because factories and workers are already fully used
3. demand exceeds supply
4. firms respond by raising prices.

Causes include: rising consumer confidence and spending, lower interest rates, tax cuts, higher government spending, and a boom in exports.

Cost-push inflation, rising costs of production push prices up.

1. The cost of making goods rises
2. firms' profits are squeezed
3. to protect their margins they raise prices
4. and because output is more expensive to produce, firms may produce less.

Causes include: higher wages, dearer raw materials and energy, a fall in the exchange rate making imports dearer, and higher indirect taxes.

The difference matters for policy. Demand-pull inflation can be reduced by cooling demand, raising interest rates or taxes. Doing the same to cost-push inflation reduces output and raises unemployment without removing the cause.

A third cause: expectations. If people expect prices to rise, workers ask for higher wages and firms raise prices in advance. That makes the inflation happen, a wage–price spiral that keeps itself going.

Consequences of inflation

Who loses:

• People on fixed incomes, such as pensioners, whose money buys less each year.
• Savers, if the interest they earn is lower than the inflation rate, the real value of their savings falls.
• Lenders, who are repaid in money worth less than they lent.
• Exporters, because domestic goods become expensive compared with foreign ones, so the country becomes less internationally competitive.
• Firms planning ahead, since uncertainty about future prices and costs discourages investment.
• Workers, unless their wages rise by at least as much as prices.

Who gains:

• Borrowers, who repay debts in money worth less than they borrowed.
• Firms holding stock that rises in value.

Other effects: menu costs (the cost of constantly changing prices and labels) and shoe-leather costs (time and effort spent searching for the best prices).

Why deflation is also a problem, a point that earns marks:

1. Prices are falling
2. consumers delay purchases, expecting things to be cheaper next month
3. demand falls further
4. firms cut output and jobs
5. prices fall again. Meanwhile the real value of people's debts rises, squeezing borrowers.

That is why the target is around 2%, not 0%.

Worked example

World oil prices double.

1. Oil is used in producing and transporting almost everything
2. firms' costs of production rise sharply
3. to protect their profits they raise prices
4. this is cost-push inflation.

At the same time, because producing is now more expensive, some firms cut output and jobs, so the country gets rising prices and rising unemployment together.

Effects on different groups:

• Households face a higher cost of living. The effect is regressive, because energy and transport take a bigger share of a low income.
• Firms face squeezed profits, and those unable to pass costs on may fail.
• Savers and pensioners lose, as their money buys less.
• Exporters lose competitiveness as domestic prices rise faster than rivals' abroad.

What could the government do, and what is wrong with each option?

• Raise interest rates to cool demand. But this is demand-pull medicine for a cost-push problem; it would reduce spending and raise unemployment without doing anything about the oil price.
• Do nothing and wait, on the grounds that a one-off price rise will work its way through. But if people come to expect higher inflation, wage demands could turn a one-off shock into lasting inflation.
• Supply-side measures: energy efficiency, alternative energy sources, attack the real cause, but take years.

Judgement: there is no painless option. Since the cause is a cost shock from abroad, holding steady while helping the households worst affected is more defensible than raising interest rates, provided people do not start expecting high inflation to continue.

Common exam mistakes

• Confusing deflation (falling prices) with disinflation (prices rising more slowly).
• Saying inflation means "prices are high". It means prices are rising.
• Treating all inflation as demand-pull, when the cause and cure differ for cost-push.
• Saying inflation harms everyone, borrowers gain.
• Forgetting that deflation is also harmful.
• Describing the CPI without mentioning weighting, which is the whole point of the basket.

Exam technique

Define inflation as "a sustained rise in the general price level", the exact phrase is worth marks.

Say which type of inflation you are discussing and give the mechanism: for cost-push, "costs rise → firms raise prices to protect profit margins"; for demand-pull, "demand exceeds what the economy can produce → firms raise prices".

For consequences, organise by who is affected, savers, borrowers, those on fixed incomes, firms, exporters. That structure produces several developed points quickly.

Quick revision

• Inflation = a sustained rise in the general price level. Deflation = falling prices. Disinflation = rising more slowly.
• CPI: a weighted basket of goods, prices collected monthly, compared with a base year. Target usually 2%.
• CPI problems: it is an average, updated yearly, poor at handling quality changes, ignores the informal economy.
• Demand-pull: too much demand chasing too few goods.
• Cost-push: rising production costs, wages, raw materials, a weaker exchange rate, higher indirect taxes.
• Expectations can create a wage–price spiral.
• Losers: fixed incomes, savers, lenders, exporters, firms planning ahead. Winners: borrowers.
• Deflation is also harmful: delayed spending and a rising real value of debt.

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