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Chapter 3.4 - Price Stability (Key Definitions (Rate of Inflation = The…
Chapter 3.4 - Price Stability
Key Definitions
Rate of Inflation
= The percentage rise in the general price level over time
Consumer Price Index (CPI)
= Method used to calculate the rate of inflation
Price Stability
= When the general level of prices stays constant over time, or grows at an acceptably low rate
Inflation
= A sustained rise in the general price level over time
Cost of Living
= The price level of goods and services bought by the average family
How is Inflation Measured?
The government considers spending of an average household
The government complies a "basket" of typical products
The government records prices of the products at hundreds of retail outlets
All the prices are recorded, put together and give the number 100 at the start of the period
If prices rise, this is then reflected in the index
Real vs Nominal Values
The real value takes into account the effect of inflation
A nominal value is the face value of something expressed in money terms
Demand-Pull Inflation
When economy is near full employment --> it is difficult to find enough workers --> the economy struggles to produce enough output --> price level rises
economic boom --> high levels of employment --> high per capita incomes --> more money supply --> total consumer demand rises --> firms raise prices
2 causes for it:
Cost-Push Inflation
When rises in costs of production cause firms to increase prices, raising the overall price level in the economy
Cost-Push Productivity of Labor
Productivity
= Output per worker per period of time
If productivity rises --> costs per unit fall --> firms produce more --> sell more --> get more revenue
So if productivity rises, and wage rises by more, there is an increased cost per unit
Consequences of Inflation
Consumers
Consumer Confidence Calls
When there is inflation, prices may be unstable and consumers can't plan their spending
Debtors Gain
Debtors gain, because if there is inflation, the real value of what they owe decreases
Shoe Leather Costs
As prices change for often, consumers and firms waste more time looking for the good prices, because they are unsure what prices are actually "good" as they are constantly changing
Income Redistribution Problems
Workers in strong trade unions might be able to keep their income up with inflation. However others with weak bargaining power will suffer
Real Incomes Fall
Consumers have limited income. If their nominal income increases by less than inflation or stays the same, then their real income falls
Government
Gains as Debtor
Government owes money to individuals and over time money loses value (in real terms), therefore they gain
Policy Needs to Combat Inflation
Inflation can have drastic consequences for an economy. It is an essential government policy to control inflation
Spends more as Provider of Benefits
Government needs to raise benefits in line with inflation, meaning they spend more money on benefits
Receives More in Tax
Government will collect more revenue in times of inflation as wages and prices are rising
Spends More as a Major Employer
Government needs to raise finance in order to pay for their employees in times of inflation
Savers
Purchasing Power of Money Falls
Inflation makes the purchasing power of money fall, meaning money kept as savings loses value (in real terms) over time, therefore savers lose during inflation
Producers
Producers Lack Business Confidence
High rates of inflation can seriously reduce business confidence meaning businesses are much less likely to invest
Producers Lose as Creditors
The value of the loans debtors repay to creditors loses its real value over time
More Flexibility
Inflation allows greater flexibility for firms. This is because they can increase workers wages by less than inflation, but in times of 0% inflation, people wont accept a wage cut
Menu Costs
Firms will have to adjust prices more often when there is inflation which will cost money and/or time
Unemployment
As inflation makes the UK economy less competitive, this will lead to unemployment
Labor Market Conflicts
Workers and their trade unions will be aware inflation is reducing the purchasing power of their wages. Therefore they may demand more pay rises as they don't want their real incomes to all