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What is inflation?
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What is inflation?
Inflation is the sustained increase in the general price level of goods/services in an economy.
How is the general price level measured?
The general price level is measured by checking the prices of a basket of goods and services that an average household purchases each month.
What is the CPI?
The CPI (consumer price index) is a weighted index of the basket of goods and services used to measure inflation.
True or False?
No inflation is better than low inflation.
False.
Low inflation is better than no inflation, as it is a sign of economic growth.
Define the term deflation.
Deflation occurs when there is a fall in the general price level of goods and services in an economy.
What is disinflation?
Disinflation refers to a reduction in the inflation rate from a higher level to a lower level, but prices are still rising e.g the rate of inflation falls from 5% to 3%.
How is the inflation rate calculated?
The inflation rate is calculated using the consumer price index.
Formula.
(New CPI - Old CPI) ÷ Old CPI x 100
Define the base year used in the CPI.
The base year for the CPI is the year in which the index is set to 100.
True or False?
The CPI includes all goods and services.
False.
The CPI only includes a basket of around 700 goods and services that an average household purchases.
What are the two main causes of inflation?
The two main causes of inflation are demand-pull inflation and cost-push inflation.
Define demand-pull inflation.
Demand-pull inflation is caused by excess demand in the economy due to increases in consumption, investment, government spending or net exports.
What are the components that make up aggregate demand?
Aggregate demand is the sum of consumption, investment, government spending and net exports.
Give an example of demand-pull inflation.
If the central bank lowers interest rates, increased borrowing can lead to higher consumption and investment, causing demand-pull inflation.
Define cost-push inflation.
Cost-push inflation is caused by increases in the costs of production like labour, raw materials or falling productivity.
What causes cost-push inflation?
Cost-push inflation occurs when higher production costs or falling productivity reduce supply, leading to higher prices.
Give an example of cost-push inflation.
If trade unions negotiate higher wages, the increased labour costs for firms can cause cost-push inflation.
How does inflation impact firms?
Inflation creates uncertainty for firms, forcing them to change prices frequently and delaying investment decisions.
How does inflation impact consumers?
Inflation decreases consumers' purchasing power and reduces the real value of savings.
How does inflation impact the government?
Inflation erodes international competitiveness but also erodes the value of government debt as repayments are worth less.
How does inflation impact workers?
Workers demand higher wages to compensate for reduced purchasing power, but if wage increases don't match inflation, motivation can fall.
True or false?
Some inflation is desirable for economic growth.
True.
Governments typically want low inflation, around 2–3%, as it signals economic growth.
What are the two causes of deflation?
The two causes of deflation are demand-side deflation and supply-side deflation.
Define demand-side deflation.
Demand-side deflation is caused by a fall in aggregate demand in the economy.
How does demand-side deflation occur?
If any component of real GDP (consumption, investment, government spending, net exports) decreases, it can lead to demand-side deflation.
What is a consequence of demand-side deflation?
With falling output during demand-side deflation, unemployment increases as fewer workers are required.
How does demand-side deflation impact consumers?
Falling output and rising unemployment cause consumers to lose confidence and reduce consumption during demand-side deflation.
How does demand-side deflation impact debt?
Debt feels more burdensome during deflation as the real value of debt increases while the price level falls.
Define supply-side deflation.
Supply-side deflation is caused by increases in productive capacity and supply in the economy.
What causes supply-side deflation?
Supply-side deflation occurs due to increases in the quantity or quality of factors of production like labour, capital, etc.
What is a consequence of supply-side deflation?
With rising output during supply-side deflation, more workers are required so unemployment falls.
How does supply-side deflation impact consumers?
Falling prices and rising output cause consumers to gain confidence and increase consumption during supply-side deflation.
True or false?
Both types of deflation are undesirable.
False.
While demand-side deflation is undesirable, supply-side deflation that increases output is desirable for an economy.
How does deflation impact exports?
Persistently falling prices can make exports more attractive to foreign buyers during deflation.
What policies best address demand-pull inflation?
Contractionary demand-side policies like fiscal and monetary policy aim to reduce aggregate demand to tackle demand-pull inflation.
Give an example of a contractionary fiscal policy.
Contractionary fiscal policy includes:
Increasing corporate tax
Increasing personal income tax
Decreasing government spending
Define contractionary monetary policy.
Contractionary monetary policy raises interest rates or reduces the money supply to decrease spending and inflation.
What are two drawbacks of contractionary policies?
Two drawbacks of contractionary policies include:
Contractionary policies decrease national output
Contractionary policies lead to lower employment in the economy
What policies best address cost-push inflation?
Supply-side policies that improve productivity and reduce costs aim to tackle cost-push inflation.
State one supply-side policy used to tackle inflation.
Supply side policies used to tackle inflation include:
Deregulation
Reformation of the labour market
Subsidising key industries
Providing increased education and training
Define expansionary fiscal policy.
Expansionary fiscal policy increases government spending or reduces taxes to boost household income and consumption.
State one example of expansionary monetary policy.
One example of expansionary monetary policy includes:
Lowering interest rates
Depreciating the exchange rate
Increasing the use of quantitative easing
What is one drawback of expansionary monetary policy?
One drawback of expansionary monetary policy includes:
It increase income inequality as the poorest households may not benefit
It may cause demand pull inflation
True or False?
Supply-side policies address deflation.
False.
Supply-side policies do not directly address deflation.