# Inflation

You will have to review your AS notes, 2.6 Inflation and Deflation, before starting this unit.  You will also be tested on this knowledge in the Unit 4 exam.

Many of the topics covered there, particularly costs and policies to control inflation, are essential knowledge at A2.

This unit will extend your knowledge as we look at index numbers in greater detail, understand how CPI is calculated, the causes of inflation and the impact of deflation and hyperinflation on the economy.

## Index Numbers

An index number enables economic data to be compared quickly over time.  One year is assigned as a base year and is given a value of 100.

In the table below 2005 is the base year.  The consumer price index for other years is shown as a percentage difference from the value of 100 in 2005, for example, in 2008 the CPI was 108.5 therefore consumer prices were 8.5% higher than in 2005.  Similarly, in 1993 the CPI was 82.1 therefore consumer prices were 17.9% lower than in 2005.

It is easy to calculate percentage changes that involve the base year, however other percentages changes must be calculated, the following formula is used:

 Index numbert – index numbert-1 index numbert-1 X 100      = % change

This is very similar to a formula that you might remember from GCSE Maths

 Change Original X 100      = % change

To calculate the annual inflation rate for 2008:

 108.5 – 104.7 104.7 X 100 3.8 104.7 X 100 = 3.6%

Calculate the inflation rates for 2006, 2007 and 2008.  Show your workings.

Other indexes produced by the Office for National Statistics are

• Retail Price Index
• Average Earnings Index
• Producer Price Indices
• Corporate Services Price Indices
• Retail Sales Index

It is common to convert other time series data into index numbers as they enable us to reduce very large numbers into simple and manageable data.

## The Consumer Price Index

The CPI is an internationally comparable measure of inflation, it is equal to the Harmonised Index of Consumer Prices (HICP).  It is calculated according to rules that are laid out in a number of European Regulations.

The calculation of CPI is based upon an average basket of goods bought by a UK household.  From month to month the content of the basket is fixed but its price varies, this is how the CPI figure is calculated.  The quantities or weight of the various items in the basket are chosen to reflect their importance in an average household’s budget.

### Weighting

Households spend more on some items than others; we would expect a 10% increase in the price of petrol to have greater upon the CPI than an identical increase in the price of socks.  It is for this reason the basket of goods is weighted to reflect the importance of the various items in the average shopping basket.

The relative weights are calculated based upon the information gathered in the Family Expenditure Survey (FES).  When calculating the weights, the spending of the richest 4% and low-income pensioners is excluded as their spending is significantly different from the average households’.

Is this a reasonable thing to do?

### Expenditure and Food Survey and Family Expenditure Survey

The Family Expenditure Survey is a survey of a random sample of households in the UK by the Office for National Statistics (ONS) that has been carried out since 1957.  In April 2001 the Expenditure and Food Survey (EFS) took over from the FES.  The EFS also includes questions that used to be collected by the National Food Survey (NTS) the Department for Environment, Food and Rural Affairs (DEFRA).  The ONS still reports the Family Expenditure Survey separately.

The FES is a survey of household spending on goods and services as well as household income.  The FES was originally introduced to provide information on spending patterns to enable an accurate measurement of the Retail Price Index.  It has since become an invaluable supply of economic and social data to the government and to researchers in universities.  In 2000-2001, 6637 households took part in the FES (about 1 in 2000 of all United Kingdom households); the response rate was 59% in Great Britain and 56% in Northern Ireland.  Data is collected throughout the year to cover seasonal variations in expenditures.

Households which take part in the survey are asked to:

• Complete a questionnaire which asks about regular household bills and expenditure on major but infrequent purchases.
• Fill in an individual questionnaire for each adult (aged 16 or over) which asks detailed questions about income.
• Maintain a diary of all personal expenditure kept by each adult for two weeks.
• Give a simplified diary to children aged 7 to 15 years which they complete over two weeks.

The survey found that UK households spent an average of £459 a week in 2007 compared to £449 in 2006.  The findings of the survey are found in the table below.

Transport accounted for the largest proportion of spending in 2007 at £62 a week; this included £22.80 on the buying of vehicles, £28.80 on fuel, repairs and servicing, and £10.10 on public transport fares.

Recreation and culture accounted for £57 a week; this includes spending on TVs, computers, newspapers, books, and holidays.  Spending of foreign holidays, at £12.50 a week, still significantly outstrips spending on UK holidays, £0.90 a week.  Housing (which does not include mortgage costs), fuel and power was the third highest category at £52 a week.

The average weekly household spending was highest by households with two adults and two children, at £690 a week. The lowest expenditure at £165 a week was by one person retired households who were mainly dependent on the state pension.

The survey also highlights how patterns in the ownership of durable goods have changed over the years. In 1997-98, 20% of households owned a mobile phone compared to78% in 2007.  Home computer ownership has grown from 29% in 1997-98 to 70% in 2007, whilst homes with the internet has increased from 9% when the survey started recording figures in 1998-99, to 61% in 2007.

### Collecting Prices

The index is always based upon a Tuesday near the middle of each month.  Price collectors record about 110,000 prices for over 550 every month by visiting a variety of shops in approximately 150 places all over the UK.  This means having to visit most local shops in order to collect prices at first hand, although some work can be done by telephone.  The price collectors go to the same shops each month so like with like comparisons can be made.

For around 110 goods and services it is easier to collect prices centrally, for example, TV licences, water rates, newspapers, Council Tax and rail fares.  Some large businesses with many shops send their pricing information directly to the ONS.

As it can often take longer than one day to collect all the prices, some of them are collected on the Monday or the Wednesday.  Certain prices such as those for petrol or those which can be collected centrally always relate to the Tuesday.

### Criticisms of CPI as a Measure

There are a number of limitations of using the CPI as a measure of inflation:

• The CPI does not include house prices despite the high cost of mortgage payments for many households.
• As the CPI represents an average household’s spending patterns, it will fail to represent many homes.  Homes without smokers or a car will find the CPI data doesn’t reflect their costs of living.
• The CPI may over-estimate inflation. Price rises may hide improvements in the quality of goods and services. Prices of many cars and electrical goods have fallen in real terms over the last 30 years, whilst new innovations have made  them significantly different to (and better than) early versions.
• The retail price index is slow to adjust for quality improvements in the goods sold; if one good is discontinued then it is important it’s replaced by one of a similar quality.
• The CPI can be slow to introduce new goods as the basket is only changed once each year.  Fast moving markets with fashions changing and new products being introduced can be the basket of goods doesn’t reflect an average family’s basket.
• CPI data is only provided for the UK as a whole.  Some have suggested that the UK follows Germany’s lead and breaks down CPI data by region.  The UK system is based upon when the government wanted to encourage wage bargaining at a national level.

Evaluate which you believe are the two most relevant criticisms of the CPI?

## The Causes of Changes in the Price Level

### DEMAND PULL INFLATION

Demand Pull inflation will occur when there is an increase in consumption, investment, government spending or exports minus imports.  The degree of demand pull inflation that will occur after a shift in AD will depend upon the elasticity of the aggregate supply curve.

Use the diagrams below to demonstrate the effect of a shift in AD on the level of demand pull inflation?

### COST PUSH INFLATION

Cost push inflation occurs when the short run aggregate supply curve shifts to the left.  It reflects that an increase in the firm’s costs will lead to increases in the price level.

Outline some examples of factors that would lead to the short run aggregate supply curve shifting to the left.

Show a shift to the left of aggregate supply and the impact upon the equilibrium price and national income.

If there is an increase in a business’s costs it won’t always pass on the increase in costs to the customers as it will fear losing market share; this is especially true for businesses that sell an elastic good or service.

## Fisher’s Equation of Exchange

Fisher’s equation of exchange, also known as the quantity theory of money, explains why an increase in the money supply will lead to an increase in the price level.  This is an explanation for how monetary inflation occurs.  This is demonstrated by the following equation where

• M = Money Supply
• P = Price level
• V = Velocity of Circulation – this is the number of times that a pound circulates around the economy in a year
• T = Transactions – the number of transactions that occur during the course of a year, this is also equal to the level of output.

M.V = P.T

Monetarists assume that both V and T are fixed and determined independently of the money supply, in other words, we don not expect the values of V or T to change.  If V and T are fixed then changes in M must lead to changes in P, in other words, a change in the money supply will lead to a change in the price level.  The reasons why an increase in the money supply leads to an increase in the price level are as follows:

• Consumers will spend any extra money on goods and services.

How will this affect the AD curve?

How will this change in the AD curve affect the price level?  How will the elasticity of the AS curve affect this change in the price level?  Demonstrate your answer using the chart below.

• The increase in demand for goods and services will lead to an increase in demand for labour.

What will happen to the cost of labour?

How can this impact upon the price level? Demonstrate your answer using the chart below.

• An increase in consumption will affect the level of imports into the UK.

What would you expect to happen to the volume of imports?

How would this impact upon the value of the pound?  Show the effect on the equilibrium price on the diagram below.

How would this change in the value of the pound affect the price of imports?  Use a numerical example to help explain your answer.

Why is this known as imported inflation?

The adaptive expectations hypothesis states that individuals will form their expectations of this year based upon what happened last year.  Adaptive expectations will assume that inflation in the coming year, Pt, will be equal to last year’s rate of inflation, Pt-1.  This is shown by the following formula:

Pt = Pt-1

This implies that people will learn from their mistakes; they will adjust their predictions based upon last year’s actual figure.  Of course, this is a rather simplistic model as it doesn’t take into account any views about future changes.

## The Impact of Deflation

Deflation is a fall in the price level in the economy.  Consumers will delay purchases as they will wait for the prices to fall further, thereby leading to a decrease in consumption.

What does the accelerator model assume will happen to investment in response to this fall in consumption?  Show the shift in consumption and investment on the diagram below.

What has happened to the price level, national income and level of unemployment?

This is known as a downward spiral.

There have been a number of examples of deflation occurring over the past 100 years:

• The UK experienced deflation of approximately 10% in 1921, 14% in 1922, and between 3 and 5% in the early 1930s.
• During the USA’s Great Depression, the rate of deflation was around 10% between 1930 and 1933.
• Japan experienced deflation from 1997 to 2006.

• Ireland experienced deflation when prices fell by 0.1% in January 2009.

## Hyperinflation

If inflation reaches levels of 100% or even 1,000% it is described as hyperinflation.  Whilst there is no concrete definition of hyperinflation, it is accepted to be very high or out of control.  During these times firms will constantly increase prices to cover their rising costs, workers will demand higher wages to cover rising prices and the economy will move into a dramatic wage price spiral.  Individuals won’t save as the value of money falls so rapidly.

There have been more examples of hyperinflation than deflation over the past 100 years, the following is a small selection of examples:

• Germany went through its worst inflation in 1923 when the rate of inflation hit 32,500,000% per month and prices doubled every two days.
• The Greek monthly inflation rate reached 8.5 billion percent in October 1944.
• Hungary experienced the world’s worst hyperinflation after the Second World War.  In 1944, its highest denomination note was 1,000 pengő. By the end of 1945, it was 10,000,000 pengő. By mid-1946 it was 100,000,000,000,000,000,000 pengő.  The currency’s value was announced each day on the radio.  Monthly inflation peaked at 13,000,000,000,000,000% leading to prices doubling every 15 hours.  When the pengo was replaced in August 1946 by the forint, the total value of all Hungarian banknotes in circulation amounted to one-thousandth of one US dollar.
• Zimbabwe’s inflation reached 624% in 2004, then fell back to low triple digits before surging to a new high of 1,730% in 2006.  In June 2007, inflation in had risen to 11,000%.  One year later, June 2008, monthly inflation officially reached over 11,250,000%, giving an annual inflation rate of 231,000,000% with prices doubling every 17 days.  By November 2008 it had climbed further still to an annual rate of 516,000,000,000,000,000,000%.

Hyperinflation in Hell, by Yoram Bauman, Ph.D., “the world’s first and only stand-up economist”. I dare you to try and not laugh…