1. Inflation Learning outcome AC Define inflation
SBC Economics
Inflation
Learning outcome AC
Define inflation
Explain how inflation is measured
Describe the pattern of inflation in the UK in recent years
Explain the causes of inflation and explain the processes with AS/AS curves
Calculate using the Fisher formula (Quantity theory)
Explain the effects of inflation
Evaluate the various counter inflationary policies
Reading: Units 28 and 89

2. A rise in the general price level
Inflation
A rise in the general price level

3. Inflation A fall in the general price level is described as deflation
When inflation is very high it is described as hyper-inflation i.e. inflation of 2000% in Russia in 1992

5. Measuring inflation Measuring the change in prices is a difficult task
Prices in the economy are represented by a ‘basket of goods’
The basket of goods contains goods and services that are commonly bought
People find the prices of the goods and services over the country
These prices are then used to calculate the average change in the price level

6. Measuring inflation
In the UK inflation is measured using the retail price index (RPI) and the consumer price index (CPI)
The RPI was the traditional index used to calculate inflation in the UK, it was however replaced with the CPI which was a common measure used in all EU countries
There is one other measure known as the RPIX; this is the same as the RPI except that it excludes mortgage interest payments

7. Causes of inflation There are three main causes of inflation:
Demand-pull inflation
Cost-push inflation
Growth in the money supply

8. Demand-pull inflation
Demand-pull inflation is caused by increases in aggregate demand (outward shifts of the AD curve)
As AD shifts outwards firms will increase output and increase their prices
The extent of the increase in prices depends on the shape of the AS curve
Persistent demand-pull inflation is caused by continuous outward shifts in AD as may be seen during a boom

9. Demand-pull inflation
Price
level AS P2 Q2 P1
AD2
AD1 O Q1
National output

10. Cost-push inflation
Cost-push inflation is caused by decreases in aggregate supply (inward shifts of the AS curve)
As firms face an increase in costs they will decrease output and increase their prices
The extent of the increase in prices depends on the shape of the AD curve
Persistent cost-push inflation is caused by continuous inward shifts in AS as may be seen when wages are consistently rising

11. Cost-push inflation AS2 AS1 AD Price level P2 Q2 P1 O Q1
National output

12. Growth in the money supply
The Quantity theory of money (Fisher formula) states that:
MV=PT
Where:
M = money supply
V = velocity of circulation
P = price level
T = number of transactions

13. Growth in the money supply
Using the Fisher formula it can be seen that if there is an increase in the money supply (M) the result will be an increase in the price level (P)
The rise in the price level is inflation caused by growth in the money supply
Moderate growth in the money supply is acceptable, however excessive growth in the money supply will cause inflationary problems

14. Inflation
Inflation is generally considered to be a problem, the higher the rate the greater the problem
There are a number of costs of inflation, namely:
Shoe leather costs
Menu costs
Psychological costs
Redistribution of income
Unemployment and growth
Investment
Trade
Lending and saving

15. Costs of inflation Shoe leather costs
When inflation is low consumers and firms know what the market price is
When inflation is higher consumers will have less idea of the market price and will search around for the lowest price, the time spent doing this is a cost
When inflation is high consumers will prefer to keep their money in the bank rather than in cash, they have to go to the bank more often when they need money, the time spent doing this is a cost

16. Costs of inflation Menu costs
When there is inflation firms will have to change their prices
Restaurants will have to print new menus
Shops will have to change their price labels
Firms will need to alter vending machines and parking meters

17. Costs of inflation Psychological
When there is inflation people see prices increasing, they feel as if they are worse off (even if their incomes are increasing)
Redistribution of income
Inflation reduces the value of money
People earning a fixed income will see the value of their income reduced
It will reduce the value of money saved in the bank
If tax allowances and tax bands are not changed people will pay a higher % of their income in tax

18. Costs of inflation Unemployment and growth
Inflation increases the costs of production and creates uncertainty
This lowers the level of investment
Investment
Lower investment results in lower economic growth and creates unemployment

19. Costs of inflation Trade
If inflation is greater than in other countries and the value of the currency does not change then exports will become less competitive and imports more competitive
The result is a worsening of the trade balance
Lending and saving
Inflation erodes the value of money and therefore people that save will be worse off and those that borrow will be better off

20. Counter inflationary policies
Inflation can be controlled using:
Monetary policy
Fiscal policy
Exchange rate policy

21. Monetary policy Monetary policy can effect aggregate demand
If the government (or central bank) use deflationary monetary policy then AD will shift inwards and there will be a decrease in the price level (lower inflation)
Examples: raise the interest rate, reduce the money supply, restrict the availability of credit

22. Fiscal policy Fiscal policy can effect aggregate demand
If the government use deflationary fiscal policy then AD will shift inwards and there will be a decrease in the price level (lower inflation)
Examples: cut government spending, increase the tax rate

23. Exchange rate policy
Exchange rates can be used to control inflation; it works in two ways:
Firstly, a higher exchange rate (stronger currency) will make imports relatively cheaper thus reducing the price level
Secondly, a higher exchange rate (stronger currency) will lead to a fall in exports and a rise in imports (X↓ M↑) this will lead to a decrease in aggregate demand and the AD curve will shift inwards

24. Deflationary policy AS AD1 AD2 Price level P1 P2 O Q2 Q1
Monetary policy, fiscal policy or exchange rate policy can be used to shift the AD curve inwards and therefore reduce the rate of inflation
Price level AS P1 P2
AD1
AD2 O Q2 Q1
National output