Key Terms
Inflation: A general and sustained increase in the average price level.
Deflation: A fall in the general price level.
CPI (Consumer Price Index): A measure that examines the average of prices of a basket of consumer goods.
Deflation: A fall in the general price level.
CPI (Consumer Price Index): A measure that examines the average of prices of a basket of consumer goods.
Theory
What is inflation?
When inflation exists in the economy the purchasing power of money falls. Every pound (£) you own buys less of a good or service. Think of it like this, if inflation is at an annual rate of 2% then theoretically a £1 bag of HARIBO will cost £1.02 in a years time.
Measurement of Inflation
Causes of Inflation
Demand-pull inflation:
When a component of aggregate demand increases the AD curve shifts right and is said to 'pull' up the price level thus causing inflation.
Cost-push inflation:
Cost-push inflation arises when the economy experiences an increase in costs of production. For example when the price of labour (wages) increases firms increase prices in order to maintain their profit.
Policies to Control Inflation
Demand-side methods:
Supply-side methods:
Consequences of Inflation
1) Reduced Competitiveness
Inflation reduces the spending power of money, therefore on the global market, exports become more expensive and imports relatively cheaper.
2) Redcued Confidence
Inflation makes spending unpredictable, this reduces business confidence and offsets direct investment into the economy.
3) Wage-price spiral
Workers recognise that inflation reduces the real value of their wages. As a result the work force bargin for higher wages which further affects inflation. This can create even more problems (such as reduces productivity) if wage bargaining turns into strikes and protests.
4) Menu costs
Inflation also create other problems for firms such as menu costs. This is where firms incur additional costs because they frequently change their menu's and prices in order to keep up with inflation.
Inflation reduces the spending power of money, therefore on the global market, exports become more expensive and imports relatively cheaper.
2) Redcued Confidence
Inflation makes spending unpredictable, this reduces business confidence and offsets direct investment into the economy.
3) Wage-price spiral
Workers recognise that inflation reduces the real value of their wages. As a result the work force bargin for higher wages which further affects inflation. This can create even more problems (such as reduces productivity) if wage bargaining turns into strikes and protests.
4) Menu costs
Inflation also create other problems for firms such as menu costs. This is where firms incur additional costs because they frequently change their menu's and prices in order to keep up with inflation.