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Inflation and deflation

Inflation: a sustained increase in the general price level in an economy.

Deflation: a persistent fall in the general price level of goods and services.

Inflation does not mean every price is rising. Some prices may stay the same or even fall, but on average prices are going up. If the inflation rate is 3%, goods that cost $200 last year cost about $206 this year. Deflation means the inflation rate is negative.

Governments aim for inflation that is low and stable, and many set a target, such as 2% a year.

Measuring inflation: the consumer price index (CPI)

Consumer price index (CPI): measure of the general price level (excluding housing costs).

How the CPI is worked out:

• Collecting prices: each month, government statisticians note the prices of hundreds of goods and services bought by thousands of households.
• Averaging: an average price is worked out from all this information.
• Index number: the average is turned into an index number. A base year is set at 100, so prices in other years can be compared with it.

Formula:

Rate of inflation = (CPI this year – CPI last year) ÷ CPI last year × 100

Give the answer as a percentage, with the % sign, usually to two decimal places. If the starting figure is the base year (100), the change in the index is the percentage rise in prices, e.g. a CPI of 105.4 means prices have risen by 5.4% since the base year.

Types of inflation

Demand-pull inflation

Demand-pull inflation: inflation caused by too much demand in the economy relative to supply.

Just as a rise in demand pushes up the price in one market, a rise in total demand pushes up the general price level. This is most likely when nearly everyone who wants a job has one, close to full employment. Firms are near full capacity, so they cannot produce enough extra output and raise their prices instead.

Causes of demand-pull inflation:

• Rising consumer spending: e.g. because of lower taxes or cheap borrowing.
• Large increases in government spending: e.g. on new roads and hospitals.
• Firms demanding more resources: e.g. more raw materials and machinery to expand.
• Booming demand for exports: foreign buyers want more of the country’s goods.

Cost-push inflation

Cost-push inflation: inflation caused by rising business costs.

When their costs rise, firms put up prices so that their profit margins do not shrink. If many firms do this, the general price level rises.

Causes of cost-push inflation:

• Higher import prices: e.g. a rise in the price of imported oil or raw materials.
• Wage increases: e.g. when trade unions win pay rises, firms pass the extra cost on in higher prices.
• Higher taxes: e.g. a rise in VAT adds to prices.
• Firms seeking more profit: raising selling prices to earn higher profits also pushes prices up.

The relationship between inflation and interest rates

An interest rate is the cost of borrowing, or the return on savings.

How interest rates affect inflation:

• Low interest rates: borrowing is cheap, so households and firms borrow more and spend more. If demand rises faster than output, prices are pulled up and inflation rises.
• High interest rates: borrowing is more expensive and saving is more attractive, so households and firms borrow and spend less. Demand falls, which takes pressure off prices, so inflation falls.

Higher interest rates can also raise the exchange rate. Imports then become cheaper for consumers and firms, which can ease cost-push inflation.

The impact of inflation

Menu costs: costs to firms of having to make repeated price changes.

Shoe leather costs: The costs to firms and consumers of searching for the lowest prices when inflation is high/prices are rising rapidly.

Nine impacts of inflation:

• Prices: rising prices reduce the purchasing power of money, so people can buy less with their income and their living standards fall. This is not a problem for people whose income rises as fast as prices, or faster.
• Wages: workers ask for pay rises so their wages keep pace with prices. Higher wages raise firms’ costs, so firms raise prices again, which can lead to a wage-price spiral. Disputes over pay can also lead to strikes.
• Exports: if inflation is higher than in other countries, exports become more expensive. Demand for them falls, which harms the balance of payments and can cost jobs in exporting firms.
• Unemployment: rising prices often come with rising demand, so firms produce more and take on workers, reducing unemployment. However, very high inflation can come with rising unemployment.
• Menu costs: firms have to change their prices often, which costs money, e.g. reprinting brochures and menus, updating websites and telling staff.
• Shoe leather costs: consumers and firms spend more time shopping around for the lowest prices and best value.
• Uncertainty: firms cannot predict prices even a few months ahead, so planning is hard. Setting a price for a long-term contract is also difficult.
• Business and consumer confidence: worried consumers borrow less and save more, which reduces demand. Worried firms put off growth plans and spend less on developing new products, so economic growth tends to slow.
• Investment: investment means spending large sums now for returns over many years. Uncertainty about future prices means firms may delay or cancel investment projects, which harms future growth and jobs.