IGCSE Economics Price inflation

Zimbabwe inflation hits 231 million per cent What is inflation? Inflation is a general and sustained rise in the level of prices of goods and services i.e. prices of the vast majority of goods and services keep on rising 9 October 2008 Zimbabwe inflation hits 231 million per cent A loaf of bread, which cost Z$500 at the beginning of August, now costs between Z$7,000 and Z$10,000 Some countries have experienced hyperinflation in the past: runaway inflation during which prices rise at phenomenal rates and money becomes almost worthless

How to measure inflation There are many millions of different goods and services exchanged in an economy, so most countries track the prices of a selection of goods and services to construct a price index Year 0 (base year) Identify the basket of goods and services purchased by the ‘typical’ family Monitor the ‘average’ price of each item in the basket at a sample of different retail outlets Monitor how much the ‘typical’ family spends on each item in the basket Weight the average price of each item by the proportion of household expenditure spent on it Add up all the weighted average prices Set the total weighted average price of the basket equal to 100 Year 1 onwards Repeat the monitoring of household spending patterns and prices Compare the total weighted average price of the basket to base year to calculate the change in the price index

Calculating a consumer price index Price of basket was $25 in base year, so annual inflation has been 8%, i.e. Note: The basket of goods and services bought and the weights applied to each item in the basket may change from year to year as products and spending patterns change

RPI or CPI? Most countries compile a consumer price index (CPI) or a retail price index (RPI), or both The methodology used for each index series is the same, but the products they include and the types of consumer they cover can differ. As a result they can provide slightly different measures of inflation

Uses of price indices As an economic indicator A consumer or retail price index is a widely used measure of price inflation and therefore a measure of changes in the cost of living As a price deflator Rising prices reduce the purchasing power of wages, profits, pensions, savings, tax revenues, and a host of other economic variables of importance to different groups of people and decision makers. A price index is therefore used to calculate changes in their real values over time For indexation Indexation involves increasing certain payments and values, such as state pensions and income tax thresholds, by the annual rate of increase in price inflation in order to keep their real value constant

What causes inflation? Economists today tend to agree that the main cause of inflation is ‘too much money chasing too few goods’ i.e. if the money supply increases at a faster rate than the aggregate supply of goods and services then the general level of prices will rise The money supply may expand to meet demand and cost pressures ►

Demand-pull or cost-push inflation? A demand-pull inflation is caused by aggregate demand rising faster than the aggregate supply of goods and services A cost-push inflation is caused by rising wages and other production costs. Firms will raise their prices to cover these additional costs A rise in import prices may cause an imported inflation. Import prices may rise following a fall in the exchange rate of the importing country

The costs of inflation Low and stable price inflation can be beneficial for an economy: It encourages consumers to buy goods and services sooner rather than later It reduces the real cost of loan repayments But high or rising inflation can be bad for an economy: Inflation erodes the value or purchasing power of money. People, especially those on low and fixed incomes, cannot buy as much as they did before with their incomes. Demand for many products will fall if real incomes continue to be squeezed It increases the costs of production and reduces profits margins It reduces the price competitiveness of exports It creates economic uncertainty. Consumers, firms and governments will be uncertain about their future costs and the impact rising inflation could have on their incomes and revenues. Firms may cut their investment and consumers their spending Stagflation: an economic situation when unemployment and inflation are both high and/or rising

What is deflation? Japanese inflation, 1970–2010 (% annual change in CPI) Disinflation refers to a slowdown in the rate at which prices are rising in general but deflation involves a continuous decline in the general level of prices in an economy

So what’s so bad about falling prices? Increasing supply, competition, productivity and technological advance are good things for an economy and consumers, and have reduced the prices of many products over time, such as mobile phones, televisions, cars, holidays and clothing, in many countries However, when falling product prices become widespread and prolonged due to a slump in aggregate demand, the result is malign deflation In addition, the real cost of borrowing and public spending rises. Firms cut investment and the government must cut spending or raise taxes. Eventually the economy goes into a deep recession as demand, output, the demand for labour, and incomes continue to fall. Many firms may go out of business because they are unable to make any profit no matter how much they cut their prices.