Economics (9214) | Inflation and price stability

Welcome to Chapter Notes: Inflation and Price Stability

Hello future economists! This chapter is about one of the most important goals any government has: keeping prices stable. Why? Because when prices go crazy, the economy struggles, and people feel poorer. Understanding inflation is key to understanding how governments try to manage the economy, so let’s dive in!

Remember, achieving price stability is a crucial element of the section we are studying: Government Objectives (alongside economic growth, low unemployment, and a healthy balance of payments).

What is Inflation? The Shrinking Loaf Analogy

When you hear the word inflation, think about the value of money falling. If everything costs more today than it did yesterday, your money can buy less.

Definition and Key Terms

1. Inflation Defined
Inflation is defined as the sustained increase in the general price level in an economy over a period of time.

• Increase: Prices are moving upwards, not just momentarily, but consistently.
• General Price Level: This doesn't mean just one or two items are expensive (like avocados being pricey this week). It means the average price of almost everything (food, rent, transport, services) is rising.

Analogy: Imagine your grandmother gives you \$100. If there is 10% inflation this year, next year that same \$100 will only buy you 90% of what it buys today. It’s like your loaf of bread keeps shrinking, even though you paid the same amount of money for it.

Measuring Inflation: The Consumer Price Index (CPI)

How do we know if prices are actually rising? Economists use a measurement tool called the Consumer Price Index (CPI) (sometimes referred to as the Retail Price Index or RPI in some countries).

Step-by-Step: How CPI Works

1. The Basket of Goods: A government agency selects a "basket" representing hundreds of goods and services that a typical household buys (e.g., bread, electricity, mobile phone data, petrol, cinema tickets).
2. Weighting: More important items (like rent) are given a higher "weight" than less important items (like obscure sweets).
3. Price Collection: They track how the total cost of this basket changes over time.
4. Calculation: Inflation is the percentage increase in the cost of the basket from one year to the next.

Formula Idea (Keep it simple):
If the basket cost \$1,000 last year and costs \$1,050 this year, the inflation rate is 5%.

$$ \text{Inflation Rate} = \frac{\text{New Index Value} - \text{Old Index Value}}{\text{Old Index Value}} \times 100 $$

Quick Review: Inflation means prices rise and the purchasing power of your money falls.

The Causes of Inflation: Why Prices Go Up

Economists usually split the causes of inflation into two main categories. You must know the difference between these two!

1. Demand-Pull Inflation (Too Much Money!)

This happens when Aggregate Demand (AD)—the total spending in the economy—is growing faster than Aggregate Supply (AS)—the total production capacity of the economy.

The Core Idea: "Too many buyers are chasing too few goods."

Analogy: Think about concert tickets for a very popular band. If everyone suddenly has a lot of extra money (high demand) but there are only 10,000 seats (limited supply), the promoters can charge much higher prices.

Causes of Demand-Pull Inflation:

• High Consumer Confidence: People feel secure about their jobs and spend more (AD shifts right).
• Low Interest Rates: Borrowing money becomes cheap, encouraging more loans and spending.
• Increased Government Spending: Government projects (e.g., new infrastructure) inject money into the economy, boosting demand.

Memory Aid: D-P (Demand-Pull) = Demand is Pulling prices up!

2. Cost-Push Inflation (Higher Production Costs!)

This occurs when the costs of production for firms rise, forcing them to increase their selling prices to maintain their profits. The supply curve shifts inward (to the left).

The Core Idea: Costs for businesses are being "pushed up."

Analogy: If the cost of flour (a key raw material) doubles, the baker has to raise the price of bread, even if customer demand hasn't changed.

Causes of Cost-Push Inflation:

• Wage Increases: If trade unions successfully push for much higher wages, firms must pass these higher labour costs onto consumers.
• Rising Raw Material Costs: A sudden, sharp increase in the price of key global inputs, like oil or gas (e.g., due to global conflict or supply restrictions).
• Higher Indirect Taxes: If the government increases VAT (Sales Tax), the firm’s costs increase, and they raise consumer prices.

Common Mistake to Avoid: A lot of students confuse them. Remember: Demand-Pull is about *spending* being too high. Cost-Push is about *production costs* being too high.

The Economic Consequences of Inflation

Inflation, especially when high and unpredictable, can seriously damage the economy, which is why price stability is a key government objective.

Impact on Individuals and Households

• Reduced Purchasing Power: This is the biggest impact. If your salary increases by 2% but inflation is 5%, you are 3% poorer in real terms. You can buy less with the same money.
• Winners vs. Losers:
  • Losers: People on fixed incomes (like pensions) and savers (the money saved loses value quickly).
  • Winners: Borrowers (people with mortgages or loans). The real value of their debt shrinks as inflation increases.

Impact on Firms and the Economy

• Uncertainty: High inflation makes it hard for businesses to plan. They don't know what their costs or revenues will be in six months, discouraging investment (bad for long-term growth).
• Reduced International Competitiveness: If prices rise faster domestically than they do in other countries, your country's goods become relatively expensive abroad. This harms exports and may lead to job losses.
• Shoe Leather Costs: (A small but relevant cost). People spend more time 'shopping around' to find the lowest prices rather than working or producing, wasting time and resources.

Did You Know? Economists generally agree that a very low, stable rate of inflation (around 2%) is actually healthy, as it encourages spending and discourages people from hoarding cash.

Key Takeaway: Unpredictable inflation creates winners and losers, destroys the value of savings, and makes economic planning impossible.

Price Stability, Deflation, and Disinflation

To fully understand the government's objective, we must define related terms.

1. The Government Objective: Price Stability

Price Stability does not mean 0% inflation. It means maintaining a low, steady, and predictable rate of inflation (often targeted between 1% and 3%).

Why not 0%? Because a tiny bit of inflation smooths economic adjustments and avoids the risks associated with deflation.

2. Deflation (The Opposite Problem)

Deflation is when the general price level is falling (the inflation rate is negative).

At first glance, falling prices sound great! However, severe deflation is terrible for the economy:

• Postponed Spending: Consumers delay purchases because they expect prices to be even lower tomorrow, causing demand (AD) to collapse.
• Higher Real Debt: If your income falls but your debt stays the same, the real burden of debt increases.
• Lower Profits: Falling prices mean businesses struggle to make money, leading to production cuts and job losses. Deflation is often a sign of a severe recession.

3. Disinflation (Slowing Down)

Disinflation occurs when the rate of inflation is slowing down, but prices are still rising overall.

Example: Inflation was 8% last year, and this year it is 3%. Prices are still going up (3%), but much slower than before. The economy is experiencing disinflation.

Summary: Linking Inflation to Government Objectives

The government places high importance on achieving price stability because high, unpredictable inflation (or deflation) undermines all their other objectives:

• It discourages the investment needed for economic growth.
• It reduces international competitiveness, leading to fewer exports and higher unemployment.
• It creates economic and social instability, making life harder for those on fixed incomes.

Understanding the causes and consequences of inflation is the first step in understanding the *policies* governments use to try and control it!