Limitations of measurements (CPI)

• Wholistic the office of National Statistics goes to great lengths to ensure the accuracy of its data, in reality each
household and individual will experience a different rate of inflation.
- Few people will fir the definition “average” as defined by the basket of goods and services

• The governments targeted measure of inflation is the CPI, which excludes mortgage payments and their associated
interest.
- For many households, the monthly mortgage payments represents their biggest item of
expenditure, but it is excluded from the CPI calculations.

• The CPI does not recognize improvements in the quality of goods and services over time.
- For example, the prices of many electronic items e.g television , computers have fallen in real
terms, whilst quality has improved markedly.

There are three primary causes of inflation:

1. Demand-Pull
2. Cost-Push
3. Growth of the money supply

• Demand-pull inflation is caused by excessive demand in the economy for goods and services
• There is too much money chasing too few goods and services

• The best way to think about is using the AD (Aggregate Demand) formula: C+I+G(X-M)=AD
• Consumption Investments Government Spending
• Export and imports (Net Trade)

• Consumption is the largest component of AD(aprox 60-65%),

although any stimulant to AD will create some demand-pull inflationary pressure if supply remains unchanged.

T2u Aggregate Demand

The price level is the avarge of prices for all

Pric goods and services in an economy.
e
level
Real National output is the output of the
economy taking into account inflation

We can use formula:

Real National Output (RNO) Nominal (money) National Output

Average price level
• What does ‘aggregate’ mean? AD =
‘The total demand for all goods and services in an economy at any given price level over a period of time’.
(GDP - expenditure based - the actual value of expenditure)

Causes of Demand-Pull Inflation

• Reduced taxation
‣ Increase disposable income. Consuming. AD. Economic growth

• Lower interest rates (cost of borrowing &reward for savings)

‣ Makes borrowing more attractive and savings less rewarding borrow more, consuming , AD. . EG. ,
investment

• A general rise in consumer spending

‣ Perhaps from higher incomes and consumer confidence

• Improved availability of credit

‣ Banks/Buildings Societies widen the availability of credit or make it more affordable

• A weak exchange rate

‣ Will boost export growth

• Fast growth in other countries

‣ May increase demand for UK exports

• General rise in confidence/expectations of future growth

‣ May feed through to higher consumer spending and investment.

• Certainty
‣ Links to confidence and assists consumers and firms in their spending and investment decisions.

Short run aggregate supply

Price
level 1) Begin with the equilibrium position

2) If there is a cut in interest, this makes

borrowing on credit more attractive, and
savings less rewarding so consumption may
rise.

3)This leads to rise in AD to AD1.

4) In the short-run, factor resources remain

unchanged and if demand for goods and
services rises faster than firms are able to
provide additional supply, then prices will be
‘pulled’ upwards to P1.
Real National Output

Your resources are fixed so the supply line is

A movement along the sras fixed
 Cost-Push Inflation

• Thais occurs when firms respond to rising costs of production by increasing prices.

• Firms will typically do this to protect profit margin.

• That said, firms may be able to absorb some increases in their costs of production, but they will not be able to do this
indefinitely, and so pass costs onto consumer in the form of higher prices.

Cost of Cost-Push Inflation

• Wage increase
‣ For many firms, wages are their largest single cost of production.
‣ It is likely that if prices are rising, workers will demand higher wages in order to maintain their ‘real’ incomes.
‣ If these higher wage costs are reflected in higher prices, then workers will continue to demand higher wages,
leading to wage-price spiral.

• Higher raw material costs

‣ As primary raw materials become more scare and in even greater demand, raw materials and associated
components may rise in price.