Inflation

Inflation 

Inflation is the rate of increase in the average price level of an economy, causing a decrease in the purchasing power of consumers. 

Deflation is the negative inflation. It is the decrease in the average prices in an economy. 

Disinflation is a fall in the rate of inflation. Note that inflation is still occurring during disinflation, just at a slower rate. 

Calculating inflation  

Inflation is calculated using the consumer price index (CPI). This is a weighted price index that measures the general level of prices in the UK by measuring the prices of a bundle of consumer goods and services (representative of overall consumption) at different points in time. In doing so the percentage change in CPI over time provides an estimate of the rate of inflation. 

Yet there are limitations to using CPI as a measure of rate of inflation:

- CPI doesn't take into account changes in the quality of goods/services that may be why products have risen in price. 

- CPI is not fully representative and can be inaccurate for individual households whose consumption patterns differ from the norm. 

- CPI is slow to respond to new products (though the basket is changed each year only a few swaps are made) 

- Different people have different spending patterns (e.g single parents vs families), so it is hard to encompass all consumers with the index. 

The UK government targets inflation at 2% using the CPI. 

An alternative means of calculating inflation is the retail price index (RPI). This is another measure of the average UK price levels. The RPI is similar to the CPI in that it uses a representative 'basket' of consumer goods/services to estimate the average cost of living. However, the RPI excludes pensioner households and the highest-income households when calculating the weightings. The RPI also includes some housing costs (e.g mortgage interest payments and council tax) that the CPI doesn't cover, and conversely the CPI covers some things that the RPI doesn't cover. This meant that during the financial crisis, the RPI rates plummeted as they were affected directly by interest rates falling. 

Causes of inflation 

There are two types of inflation: demand-pull and cost-push. 

Demand-pull inflation 

Caused by excessive expenditure (so excessive levels of aggregate demand). As demand increases, AD shifts out and the price level rises. This increase in aggregate demand can be caused by excessive consumption, investment, government spending or exporting, all components of AD (AD = C+I+G+(X-M)). 

However increasing any one of these components only has an inflationary effect if the economy is close to full capacity. In a negative output gap they can be very beneficial in stimulating growth. I and G may also increase productivity, shifting out AS and so offsetting the demand-pull pressures as it would create capacity to meet the extra demand. 

Cost-push inflation 

Caused by a rise in unit costs of production which may lead firms to pass higher costs onto consumers by raising the prices of the final goods/services. This leads to the AS curve shifting in, increasing the price level. 

Note the more elastic the goods are the less a firm will want to raise prices as this will decrease the quantity of the good sold, so they instead absorb the higher costs and make less profit. So greater elasticity = less cost-push inflation. 

Costs of production for firms can increase when:

Raw material prices rise 

Wages rise 

Cost of machinery increases

Rents rise

Taxes on firms increase 

Regulations imposed by government (e.g health and safety) 

Growth of money supply 

If a government increases the money supply (i.e by printing money excessively) at a rate greater than growth in real output, then the demand for goods will increase as the consumer has greater purchasing power. In response to this excessive consumption, firms will put up prices and so inflation occurs. 

However if the supply of money increases at the same rate as output increases, then prices should remain the same.