1. AS: 3.2.3 E CONOMIC PERFORMANCE 2.3.3 Inflation and deflation If a basket of goods cost £1 000 in 1990, at 2% inflation, what would it cost today?

2. 2.3.3 I NFLATION AND DEFLATION  The concepts of inflation, deflation  Demand-pull and cost-push influences on the price level  How changes in world commodity prices affect domestic inflation  How changes in other economies can affect inflation in the UK  You should understand that deflation exists when the price level is falling whereas disinflation is when the rate of inflation is falling.  You should appreciate that deflationary policies are policies to reduce aggregate demand and do not necessarily result in deflation

3. I NFLATION : A D EFINITION “The rate of change in the average price level over time.” or The sustained increase in the cost of living / fall in the purchasing power of money What does inflation mean for a family like yours?

4. W HY DOES INFLATION MATTER ?  Over time, the price of goods and services tends to rise  It is important to understand why this is the case, and what impacts this may have  If wages and earnings remain constant, then as prices rise, consumers are worse off in real terms, as their disposable income will buy less goods and services than previously  Therefore it is said that inflation erodes the value of money  Inflation is a main focus of macroeconomic policy and the Bank of England has been delegated an inflation target of 2%

5. M EASURING I NFLATION  Two principle measures 1. The Consumer Prices Index (CPI) 2. The Retail Prices Index (RPI) NB1: The preferred measure is the CPI, and this is the measure that forms the Bank of England Target. NB2: Both indexes are “weighted” Find out the difference between the CPI and RPI measures of inflation.

6. T HE B ASKET OF G OODS AND S ERVICES (1)  The Office of National Statistics (ONS) compile the CPI and RPI  Both measures are based upon a basket of goods and services which is designed to represent typical purchases of consumers throughout the UK  There are around 700 items in the basket of goods and services  Different items are weighted according to their relative importance in terms of how much their price changes impact upon consumers  For example, petrol is given a high weighting because it forms a large part of individual’s disposable income and there are few direct substitutes

7. T HE B ASKET OF G OODS AND S ERVICES (2) What goods and services do you think make up the typical household basket?

8. T HE B ASKET OF G OODS AND S ERVICES (3) The ONS update the “basket” every year to reflect changes in spending patterns. “Constants”1947 – The First Basket of Goods and Services Recent Additions BreadSewing MachinesBroadband subscriptions MilkCondensed MilkSmart phones EggsMuttonOnline gaming PetrolUnskined Wild Rabbits Blu-Ray Discs School uniformsLamp OilMusic Downloads Gas + Electricity BillsGramophone RecordsE-Books What 2 items do you think were added in 2015?

9. C AUSES OF I NFLATION There are 2 primary causes of inflation: 1. Demand-Pull 2. Cost-Push What factors are affecting inflation in the UK?

10. D EMAND -P ULL I NFLATION  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 this is using the AD formula: C + I + G + (X-M)  Remember, consumption is the largest component of AD, although any stimulant to AD will create some demand-pull inflationary pressure if supply remains unchanged

11. C AUSES OF D EMAND -P ULL I NFLATION  Reduced taxation  Increases disposable income  Lower interest rates  Makes borrowing more attractive and saving less rewarding  A general rise in consumer spending  Perhaps from higher incomes and consumer confidence  Improved availability of credit  Banks/Building 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

12. D EMAND -P ULL I NFLATION D IAGRAM Price Level Real National Output SRAS P Y 1) Begin with the equilibrium position. AD 2) If there is a cut in interest rates, this makes borrowing on credit more attractive, and saving less rewarding so consumption may rise. 3) This leads to a rise in AD to AD 1. AD 1 P1P1 Y1Y1 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 P 1.

13. C OST -P USH I NFLATION  This occurs when firms respond to rising costs of production by increasing prices  Firms will typically do this to protect profit margins  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 the consumer in the form of higher prices

14. C AUSES OF C OST -P USH I NFLATION  Wage increases  For many firms, wages is 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 a wage-price spiral  Higher raw material costs  As primary raw materials become more scarce and in even greater demand, raw materials and associated components may rise in price  Higher taxes  The government may impose higher taxes on firms; for example, corporation tax, national insurance or taxes on waste disposal  Higher import prices  A weaker exchange rate or rising prices abroad mean that imported components feed through to higher costs of production  Natural disasters  May temporarily or permanently reduce the supply of raw materials or disrupt the supply chain, adding to a firms costs

15. C OST -P USH I NFLATION D IAGRAM Price Level Real National Output SRAS P Y 1) Begin with the equilibrium position. AD 2) If there is an increase in wage rates, this will increase a firm’s costs of production. 3) This will reduce SRAS to SRAS 1 because faced with higher costs of production, firms will reduce their supply, or may even leave the industry if they cannot maintain profit margins. P1P1 Y1Y1 4) As a result, rising costs have “pushed” up prices to P 1. SRAS 1

16. D EFLATION  Deflation is a decrease in the general price level  This is not to be confused with a falling rate of inflation  For example, if the rate of inflation changes from 2.7% to 2.3%, this DOES NOT mean prices are falling  It means that prices are increasing at a slower rate  For deflation to occur, the average level of prices must be falling Read the articles about UK deflation. Why is it happening? How might the Bank of England react?

17. C AUSES AND P ROBLEMS OF D EFLATION  Deflation tends to occur during periods of very low or stagnant growth  Despite the fact that the value of money would be rising, deflation generally indicates that demand is very low or suppressed  As prices are falling consumers tend to delay purchasing decisions because they think prices will fall in future  As a result consumption slows significantly  Which is likely to mean that firms will lose the confidence to invest, thus harming aggregate demand still further

18. H OW CHANGES IN WORLD COMMODITY PRICES AFFECT DOMESTIC INFLATION  Commodities such as oil and food make up a large proportion of UK imports  This means that they have a significant impact on the price level  Many of the commodities that are bought in the UK are price inelastic products  Therefore, a rise in the world price of commodities will feed through to UK inflation The impact of oil prices on UK inflation When China sneezes!

19. H OW CHANGES IN OTHER ECONOMIES CAN AFFECT INFLATION IN THE UK  The UK is impacted in a number of ways  Emerging markets are creating a growing demand for goods and services globally. This has led to demand-pull inflation  These same markets are increasing productive capacity which has lead to lower cost products feeding through into lower prices e.g. China  The economic performance of our major trading partners such as the EU and the US will impact on demand for UK products How the Eurozone impacts on the UK

20. M ULTIPLE C HOICE 1  All other things being equal, lower inflation in an economy is most likely to be achieved if there is an increase in a) productivity b) exports c) consumption d) welfare benefits Can you explain your answer?

21. M ULTIPLE C HOICE 2  The diagram represents an economy that has experienced inflation, with the price level rising from P to P1. The most likely cause of the inflationary pressures shown in the diagram is a) a sustained increase in bank lending b) a growing budget deficit c) money wages increasing faster than productivity d) a period of time when interest rates are too low Can you explain your answer? Price Level Real National Output SRAS P P1 SRAS 1 AD

22. M ULTIPLE C HOICE 3  Deflation is most likely to a) cause consumers to delay their purchases b) lead to a rise in interest rates c) lead to a rise in imports d) reduce the real value of money that has been lent Can you explain your answer?

23. M ULTIPLE C HOICE 4  The Consumer Prices Index (CPI) rises from 100 to 105. This shows that a) The inflation rate has increased 5%. b) The average price level has increased by 5%. c) The price of every good has increased by 5%. d) Inflation in the economy is rising at a constant 5% per annum. Can you explain your answer?