1. IGCSE Economics
Price inflation

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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 ►

8. 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

9. 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

10. 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

11. 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.