Chapter 3.4 - Price Stability

Cost of living and the general price level

Cost of living - Spending on goods and services bought by the average family

When price rises, cost of living increases, people's money will not buy as much as before. The quality of life will fall.

The price level - The average of current prices across all goods and services

Definitions

Rate of inflation - The percentage rise in the general price level over time

Price stability - The general level of price is kept constant OR grows at an acceptably low rate over time

  • One of the key government objectives
    -In practice it's not 0% but 2% per annum in UK

Inflation - A sustained rise in the general price level over time
When on average prices of goods and services in the whole economy are rising - however some individual products may still fall (e.g technology becomes cheaper/prices rising)

Inflation

How is it measured

Government complies a "basket" of typical products

Government records prices of products at hundreds of retail outlets

Government considers spending of an average household

All prices are recorded, put together and given the number 100 at the start of the period
If prices rise - reflected in index - say if rise 2% index = 102

Consumer price index (CPI) - an index that measures changes in the general price level of typical consumer goods and services

Real VS Nominal Values

Nominal value - a face value of something expressed in money terms


If inflation is higher than nominal increase in income, real value of income falls, people won't be able to buy as many goods or services

Real value - takes into account the effect of inflation


If inflation is higher than nominal GDP, real value of GDP falls. Economy produces lower value goods of services

Demand- Pull inflation

Demand pull inflation - When aggregate (total) demand in the economy rises and the supply of goods and services does not increase to match it. Price level is pilled up

Cost Push Inflation

Cost push inflation - When rises in costs of production cause firms to increase prices, raising the overall price level in the economy
If costs rise, firms will raise prices to maintain their profits, raising price level

Government spending

Consumers in foreign countries

Firms demanding capital goods for investment

Wages and salaries

Raw macterials

Fuel -oil,coal

Rent and buisness taxes

Interest on loans

Causes of inflation Cost-Push

Wage price spiral
Initial rise in general price level
1.Workers demand higher wages to compensate
2.Wages paid to workers rise
3.Costs of production to firms rise
4.Firms put up prices of goods and services
5.General price level rises further

Productivity of labour

Productivity - output per worker per period of time

Productivity rises -> Cost per unit falls -> firms produce more _> sell more -> more revenue

Consequences of inflation

Consumers

Producers

Savers

Government

Real incomes fall - consumers have limited income - inflation affects income - wage rises less than rate of inflation - cost of living increases - standard of living falls

Index united income: income that keeps up with inflation, standard of living is the same

Shoe leather costs - Price change more often - more time/effort spent by consumers looking to purchase goods

Income redistribution problems
Debtors gain from inflation
Savers lose from inflation
Strong trade union - wages rises up with inflation
Low paid occupants - weak bargaining power
Low fixed incomes struggle

Debtors - gain in inflation - real value of debt goes down - debt is cheaper - higher rate of inflation

Menu Costs - firms adjust price lists more often - costs for firms - capital equipment changed more often

Labour market conflicts - workers trade unions aware inflation is reducing purchasing power of money wages - want money wage rise to keep up inflation - so real wage doesn't fall

More flexibility - inflation in growing economy - greater flexibility for firms - easier for relative prices to adjust
Wages- price of labour
Low inflation - business increase prices - consumers less likely to realise when general prices rise - remain competitive

Unemployment - Uk economy less competitive - leads to unemployment - less goods sold abroad - less output - less workers

Producers lose as creditors - debtors replay loans (ie to banks) - real value is lower

Produces lack business confidence - businesses less likely to invest if uncertain - adverse effects of economic growth

Purchasing power of money falls - money kept as savings - lose value in real terms of inflation - lose money

Government gains as debtor - net borrower (debtor) - owes money to individuals/institutions

Government spends more as a provider of benefits -operates social protection system (ie benifits) - raise with inflation, are index linked

Government spends more as a major provider - major employer of workers ie. school - faces demand for wage rises - will raise finance for this

Government receives more in tax - collects more revenue - prices money wages rise - receive higher revenue automatically
ie. VAT if government does nothing - smaller amount of tax collected

Government policy needs to combat inflation - drastic consequences if not managed - policy to control inflation