What is inflation?

How is inflation measured?

• The rate of inflation is measured by the annual percentage change in consumer prices.

• The British government has set an inflation target of 2% using the consumer price index (CPI)

• It is the job of the Bank of England to set interest rates so that aggregate demand is controlled, inflationary pressures are subdued and the inflation target is reached

• The Bank is independent of the government with control of interest rates and it is free from political intervention.

http://www.youtube.com/watch?v=SmOMp8gycMA&safe=active

• Inflation is a general and sustained increase in prices.

• It is measured by a change in a weighted index of prices such as the CPI

The CPI• The consumer price index measures price

levels• Index numbers are easy to make comparisons

with.• You can calculate inflation from this by

calculating the percentage change in the index

The RPI

• The retail price index• The RPI is a more reliable measure for

negotiating wage increases because it is more inclusive than the CPI as it takes into account housing costs e.g. mortgage interest repayments

• However it is not as reliable for international comparisons as it is unique to the UK

Other problems with CPI • Measure the cost of living for an average

household. Pensioners not included• Sampling problems – only 57% of households

respond to the survey• The 650 items in the ‘basket’ are changed only

once a year, where as peoples tastes and fashions change more frequently

• For people with atypical spending patterns e.g. vegetarians and non-drivers, the CPI will be unrepresentative.

• When the quality of goods changes, the CPI breaks down because it is not comparing like with like.

Costs and benefits of inflationSort the cards to identify costs and benefits of inflation

Shoe leather costs – consumers must shop around to find the best value goods. The time and effort taken to find the best value involves an opportunity cost

Causes of inflation

Demand pull inflation• Inflation caused by excess

demand in the economy

Cost push inflation• Inflation caused by

increases in the costs of production in the economy

Causes of Demand pull inflationWhere excessive growth in AD results in the economy moving to higher price levels. • This can result from an increase in any component of AD= C+I+G+(X-M)• E.g. an income tax cut will increase consumption resulting in demand

pull inflation

Solutions to demand pull inflation• The bank of England has been given

responsibility to target 2.0% CPI inflation. To reduce inflation it will increase interest rates thus reducing AD

Solutions to demand pull inflation

Alternatively, the government could use contractionary fiscal policy to reduce the level of AD, such as:- An increase in tax- A cut in government spending

Causes of Cost push inflation• Rising input costs e.g. rising price of oil, raw materials or components.

• Rising labour costs e.g. shortage of skilled IT workers enabling them to ask for high pay rises

• Higher import prices e.g. high inflation in other countries means the goods you import become more expensive (you ‘import inflation’)

• Increases in indirect tax e.g. increases in National insurance or an energy tax will increase the costs of producers

Solutions to cost push inflation

• The bank of England is responsible for controlling inflation

• The government also pursue policies to shift the AS curve to the right, which will bring the price level down.

• However these supply side policies take a very long time to work