Inflation

Chapter 26
 INFLATION

The general and

continuous rise in
the level of prices in
an economy.
Inflation
Sustained rise in the average price level over a period of time.
Inflation causes the average price level to rise and the value of money to fall.

Deflation
When the rate of inflation is negative e.g. -1%
deflation causes the average price level to fall and the value of money to rise.

Disinflation
When the rate of inflation is positive but falling e.g. if the rate of inflation fell from 5% to 3%- prices are
rising but at a slower rate than before
disinflation causes the average price level to rise and the value of money to fall.
 Worksheet

Inflation, deflation or disinflation?

Year Rate of price change Inflation / deflation / disinflation?
2020 +5%
2021 +4% Disinflation
2022 -3% Deflation
2023 -2% Deflation
2024 +4% Inflation
2025 +3% Disinflation

Deflation is NEGATIVE – prices decreases

Disinflation is POSITIVE – prices have increased but not as much the previous
year.
6.0

5.0
UK CPI %
4.0

3.0

2.0

1.0

0.0
Jul 2010 Jan 2011 Jul 2011 Jan 2012 Jul 2012 Jan 2013 Jul 2013 Jan 2014 Jul 2014 Jan 2015 Jul 2015 Jan 2016 Jul 2016 Jan 2017 Jul 2017 Jan 2018 Jul 2018 Jan 2019 Jul 2019 Jan 2020

-1.0
 Inflation –measured
1. UK calculates the Consumer Price Index (CPI) on
a monthly basis. This measure uses a 'shopping
basket' of approximately 700 goods and services.
2. The prices of most of these items are collected
from around 150 different locations each month.
3. The indices are weighted to reflect the
importance of the various items. E.g. % of total
expenditure
4. Multiplying weights by price changes will give the
change in consumer price index
5. Both the contents of the baskets and the weights
are updated annually.
What caused this?
 Monetarists inflation

• Low interest rates

• Increased borrowing
• Increased spending
• Increased prices- inflation
• Cost push inflation –increased costs of production
• Demand pull inflation – an increase in (aggregate) demand without a corresponding
increase in supply could cause price levels to rise
• Aggregate demand – demand from consumers, government spending, investments and
exports

Sort these into the correct column: Cost push inflation Demand pull inflation
• Increased wages
• Increased exports
• Increase in material costs
• Increased consumer confidence
• Fall in exchange rate
• A rise in government spending
• Cut in interest rate
• Increased money supply
Worksheet
29

What are the problems of high inflation?

• Consider how each of the following people would be
affected by high inflation…
• Derek Little – pensioner receiving £200/week fixed income
from his private pension plan
• Fran Jones - planning to buy a new car in the summer
• Katie Webber - has £54.70 in her piggy bank
• Mark West – exporting UK produced goods across Europe
• Assad Patel – runs 3 Dominos Pizza outlets in Milton Keynes
 Impact of inflation on:
• Prices – businesses must decide whether to increase prices or decrease profit margins. Consumers will
experience a decrease in standard of living and their purchasing power because they cannot buy as many
goods.
• Wages – employees will want salary increases to keep up with increased cost of living, this will cause a “wage
spiral” as prices must increase to cover the added cost of a wage increase
• Exports – selling goods and services to another country might become harder due to increased prices – so less
competitive
• Unemployment – Aggregate demand will increase as inflation rises. More output will mean more employment.
• Menu costs – costs of informing customers of increasing prices- reprinting materials e.g. leaflets and menus
increases
• Shoe leather costs - the costs involved with shopping around for lowest prices, finding and moving money from
one financial institute to another
• Uncertainty and Business or consumer confidence – If prices aren’t stable, they cannot plan their expenditure
for the future- planning decisions become difficult, Business and consumer confidence becomes low-
businesses postpone product development and expansion, consumers save more and spend less
• Investment – businesses will hold off on investment as they are uncertain of the outcomes- investment
postponed, product development innovation delayed
 Controlling inflation

Higher taxes will cut spending sharply and see a reduction in prices.

Increasing interest rates can help control inflation. The government can
control inflation by using interest rates, the cost of borrowing money
from banks and reward for saving in banks.
By increasing interest rates, it encourages less people to borrow money and more
people to save. Thus spending decreases and businesses must reduce prices to
attract customers (deflation/disinflation).

E.G if the interest rate is 10% and you would like to borrow $100, you will have to payback $100 + 10% = $110
 How do you calculate interest
payments?
• Homer borrows £500 from the bank to buy a new TV. The bank
charges 10% interest per year.
• How much interest does he pay in the first year?
 How much is 1%?
• £500 divided by 100

•£5
 So how much is 10%?
• £5 multiplied by 10
• £50

• Homer has to pay £50 interest in the first year

 In the second year interest rates come down to 6%

• Homer still owes the bank £500

• How much interest does Homer pay now?
• 1% is still £5

•
So 6% is £5 times 6 = £30
Why Do People Spend Less When Interest Rates Increase?
 Factors affecting inflation

The effects of inflation depend on:

• The cause of inflation
• Its rate (% increase / decrease)
• Whether the rate is accelerating or stable
• Whether the rate is the one that has been expected
• How the rate compares with that of other countries

Demand pull is less harmful than cost push, as it shows increasing output.

If there is high levels of uncertainty about the effects, this will cause the most negative
consequences e.g. not being able to effectively plan