Low & Stable Rate of Inflation (DP IB Economics)
Revision Note
An Introduction to Inflation
Inflation is the sustained increase in the average price level of goods/services in an economy
Deflation occurs when there is a fall in the average price level of goods/services in an economy
Deflation only occurs when the percentage change in prices falls below zero %
Disinflation occurs when the average price level is still rising, but at a lower rate than before
These figures demonstrate disinflation: Y1 = 5% Y2 = 4% Y3 = 2%
Inflation is increasing but at a decreasing rate
Worked Example
How would you characterise the fall in the CPI from 2018 to 2021? Explain your answer [3]
Answer:
Step 1: Study the time period and decide if you are witnessing inflation, disinflation or deflation
Disinflation (1 mark)
Step 2: Explain your answer
According to the CPI data, prices are still rising but at a decreasing rate. For example, in 2018 prices were rising at around 3%. In 2019 this increase fell to roughly 1.8%. In 2021, they were still rising but by a much lower 0.5%
(2 marks for an answer with a correct explanation which references the data)
Measuring Inflation Using the Consumer Price Index (CPI)
Inflation is the sustained increase in the average price level of goods/services in an economy
The average price level is measured by checking the prices of a 'basket' of goods/services that an average household will purchase each month
This basket of goods is turned into an index and it is called the consumer price index (CPI)
Many economies have an inflation target of 2% per annum
Low inflation is better than no inflation as it is a sign of economic growth
The inflation rate is the change in average price levels in a given time period
The inflation rate is calculated using an index with 100 as the base year
If the index is 100 in year 1 and 107 in year 2 then the inflation rate is 7%
The Consumer Price Index (CPI)
A 'household basket' of goods/services that an average family would purchase is compiled on an annual basis
A household expenditure survey is conducted to determine what goes into the basket
Each year, some goods/services exit the basket and new ones are added
The number of goods in the basket varies from country to country e.g. the UK has 700 'goods' in their basket and Singapore has 4,800
Goods/services in the basket are weighted based on the proportion of household spending
E.g. More money is spent on food than shoes, so shoes have a lower weight in the basket
Each month, prices for these goods/services are gathered from many locations across the country
These prices are averaged out
The price x the weighting determines the final value of the good/service in the basket
These final values are added together to determine the price of the 'basket'
The percentage difference in CPI between the two years is the inflation rate for the period
Worked Example
Using the information in the table, calculate the inflation rate for 2021 if the price of the basket in the base year (2019) was $400 [3]
Good | Price 2020 | Price 2021 | Weight | Basket 2020 (Price x weight) | Basket 2021 (Price x weight) |
Housing, water, electricity, gas | 950 | 1200 | 34% | 323.00 | 408.00 |
Transport | 250 | 325 | 11% | 27.50 | 35.75 |
Food | 500 | 620 | 9% | 45.00 | 55.80 |
Recreation and culture | 300 | 340 | 10% | 30.00 | 34.00 |
Clothing and footwear | 190 | 210 | 5% | 9.50 | 10.50 |
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| $435.00 | $544.05 |
Answer:
Step 1: Calculate the CPI for 2020
Step 2: Calculate the CPI for 2021
Step 3: Calculate the percentage difference between the CPI for 2021 and 2020
(3 marks for the correct answer or 1 mark for any correct working. Answers should be rounded to 2 decimal places to be correct)
The Limitations of Using the CPI
The CPI provides a level of inflation for the average basket and the basket of many households is not the average basket
Depending on what households buy the level of inflation for each one can vary significantly
As an average, it also ignores regional differences in inflation e.g. London's inflation may be much higher than Manchester's inflation
The CPI is one of several methods used by countries in determining inflation - another is the retail price index (RPI)
This can make comparisons between countries less meaningful as one may use the RPI and another the CPI
The CPI does not capture the quality of the products in the basket
Product quality changes over time and so the comparison with different time periods is less useful
The CPI only measures changes in consumption on an annual basis
Changes in consumption can occur more frequently and the index is always behind these changes
The CPI is prone to errors in data collection
It is based on a survey that goes to thousands of households each year, yet it is still a small sample
The respondents have no incentive to fill in the survey carefully and accurately
The Causes of Inflation
An increase in the average prices in an economy can be caused by demand pull inflation or cost push inflation
1. Demand Pull Inflation
Demand pull inflation is caused by excess demand in the economy
Aggregate demand (AD) is the sum of all expenditure in the economy
AD = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)
An increase in aggregate demand (AD) raises the average price level in an economy leading to demand pull inflation
Diagram Analysis
If any of the four components of AD increase (ceteris paribus), there will be a shift to the right of the AD curve from AD1 → AD2
At the original price (AP1), there is now a condition of excess demand in the economy
As prices rise, there is a contraction of AD and an extension of SRAS
Prices for goods/services are bid up from AP1 → AP2
Demand pull inflation has occurred
If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms and consumers
This will result in an increase in consumption and investment
It is likely to lead to a form of demand-pull inflation
2. Cost Push Inflation
Cost push inflation is caused by increases in the costs of production in an economy
An increase in the costs of production raises the average price level in an economy leading to cost push inflation
Diagram Analysis
If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in productivity, there will be a shift to the left of the SRAS curve from SRAS1→SRAS2
At the original price (AP1), there is now a condition of excess demand in the economy
As prices rise, there is a contraction of AD and an extension of SRAS
Prices for goods/services are bid up from AP1→AP2
Cost push inflation has occurred
The Costs of Inflation
The Impact of Inflation on Different Stakeholders
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The Causes and Costs of Deflation
Deflation occurs when there is a fall in the average price level of goods/services in an economy as measured by the consumer price index (CPI)
Deflation only occurs when the percentage change in prices falls below zero %
Deflation can be caused by either demand-side or supply-side factors
The two different causes of deflation have very different consequences for the economy
1. Demand-side Deflation (Bad Deflation)
Demand-side deflation is caused by a fall in total (aggregate) demand in the economy
Aggregate demand is the sum of all expenditures in the economy as measured by the real gross domestic product (rGDP)
rGDP = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)
If any of the four components of rGDP decrease, there will possibly be a decrease in the aggregate demand in the economy leading to a decrease in the general price level
Demand-side deflation has occurred
Aggregate demand (AD) has fallen leading to a reduction in the average price level (AP)
Diagram Analysis
The initial macroeconomic equilibrium is at AP Y
Any factor which causes a reduction in one or more of the determinants of real GDP may cause the AD curve to shift left from AD1 → AD2
This shift causes a fall in average price levels from AP to AP1
The new macroeconomic equilibrium is now at AP1 Y1
Demand-side deflation has occurred
The Consequences of Demand-side Deflation
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2. Supply-side Deflation
Supply-side deflation is caused by increases in the productive capacity of the economy
This is brought about by any increase in the quantity/quality of the factors of production
It effectively creates a condition of excess supply in the economy
Average price levels fall
National output (rGDP) increases
Short-run aggregate supply (SRAS) has increased leading to a reduction in the average price level (AP)
Diagram Analysis
The initial macroeconomic equilibrium is at AP Y
Any factor which causes an increase in the SRAS will result in the SRAS curve shifting right from SRAS → SRAS1
This shift causes a fall in average price levels from AP → AP1
The new macroeconomic equilibrium is now at AP1 Y1
Supply-side deflation has occurred
The Consequences of Supply-side Deflation
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Examiner Tip
Understanding the cause of deflation is vital to analysing the consequences of the deflation.
Falling prices caused by a recession are not good for an economy. In this scenario, national output is falling which means that fewer workers will be required to produce goods/services so unemployment will increase.
Falling prices caused by an increase in supply are good for an economy. In this scenario, national output is rising which means that more workers will be required to produce goods/services so unemployment will decrease.
The Relative Costs of Unemployment Versus Inflation
Generally, there is an inverse relationship between inflation and unemployment
When inflation increases unemployment decreases and vice versa
Each situation has consequences for the economy and governments try to limit the negative consequences
The Costs of Unemployment Versus Inflation
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Examiner Tip
When analysing inflation in data response questions, or evaluating it in longer essay questions, make certain that you consider the size of any inflation. Low Inflation is not bad but is actually a sign of a healthy economy as it is indicative of economic growth.
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