A Level Economics 81: Inflation

 1. Inflation, Disinflation, Hyperinflation, and Deflation:

a. Inflation: Inflation refers to the sustained increase in the general price level of goods and services in an economy over a period of time. When inflation occurs, each unit of currency buys fewer goods and services than it did before. Moderate inflation is considered normal in healthy economies as it can encourage spending and investment.

Example: If the inflation rate is 3%, a basket of goods that cost $100 last year will cost $103 this year.

b. Disinflation: Disinflation is a decrease in the rate of inflation. It means that prices are still rising, but at a slower rate compared to a previous period. It does not mean a decline in prices (deflation).

Example: If the inflation rate was 5% last year and is now 3% this year, it represents disinflation.

c. Hyperinflation: Hyperinflation is an extremely high and typically accelerating rate of inflation. In hyperinflationary situations, the value of a country's currency declines rapidly, leading to a loss of confidence in the currency.

Example: In a hyperinflationary economy, prices may double every few days, leading to a collapse of the country's monetary system.

d. Deflation: Deflation is the sustained decrease in the general price level of goods and services in an economy over time. It is the opposite of inflation and can be caused by a decrease in consumer demand or an increase in the supply of goods.

Example: If the inflation rate is -2%, a basket of goods that cost $100 last year will cost $98 this year.

2. Calculation of Inflation via Weighted Changes in Price Indices:

Inflation is commonly calculated using a price index, such as the Consumer Price Index (CPI) or the Producer Price Index (PPI). These indices measure changes in the price of a basket of goods and services over time. The steps to calculate inflation are as follows:

1. Select the Base Year: Choose a base year against which changes in prices will be measured. Usually, the base year index is set at 100.

2. Gather Price Data: Collect price data for a representative basket of goods and services.

3. Assign Weights: Assign weights to each item in the basket based on their relative importance in consumer spending. These weights represent the proportion of consumer spending allocated to each item.

4. Calculate Price Index: Calculate the price index for each period by dividing the total cost of the basket in that period by the total cost in the base year and multiplying by 100.

5. Calculate Inflation Rate: Calculate the inflation rate by comparing the price index of the current period with the price index of the base year, expressing the change as a percentage.

Example: Suppose the price index for the base year is 100 and the current year's price index is 110. The inflation rate would be (110-100)/100 * 100 = 10%.

3. Multiple Choice Questions (MCQs) on Inflation Indices:

1. What is the purpose of using a price index to measure inflation? a) To measure changes in the money supply b) To compare prices between different countries c) To track changes in the general price level over time d) To calculate changes in GDP

   Answer: c) To track changes in the general price level over time.

2. Disinflation occurs when: a) Prices are increasing at a slower rate b) Prices are decreasing c) Prices are increasing at an accelerating rate d) Prices remain constant

   Answer: a) Prices are increasing at a slower rate.

3. Hyperinflation is characterized by: a) A very low and stable inflation rate b) A high and stable inflation rate c) An extremely high and accelerating inflation rate d) Deflation

   Answer: c) An extremely high and accelerating inflation rate.

4. The Consumer Price Index (CPI) measures changes in: a) The prices of goods and services purchased by businesses b) The prices of goods and services purchased by consumers c) The prices of goods and services produced by businesses d) The prices of capital goods

   Answer: b) The prices of goods and services purchased by consumers.

5. Deflation occurs when: a) The rate of inflation is positive but low b) The rate of inflation is negative c) The rate of inflation is extremely high d) The rate of inflation is stable

   Answer: b) The rate of inflation is negative.

4. Major Measures of Inflation in the UK and Differences:

In the UK, the major measures of inflation are:

1. Consumer Price Index (CPI): Measures changes in the prices of a basket of goods and services purchased by households. It is the primary indicator of consumer inflation.

2. Retail Price Index (RPI): Similar to CPI but includes mortgage interest payments, making it slightly higher than the CPI.

3. Producer Price Index (PPI): Measures changes in the prices of goods and services at the wholesale level.

Differences:

• CPI focuses on consumer goods, while PPI focuses on wholesale prices.
• RPI includes housing costs like mortgage interest payments, whereas CPI does not.
• RPI is typically higher than CPI due to the inclusion of housing costs.

5. Multiple Choice Questions (MCQs) on Inflation Index Numbers:

1. The Consumer Price Index (CPI) is used to measure changes in the prices of goods and services: a) Purchased by businesses b) Purchased by consumers c) Produced by businesses d) Purchased by the government

   Answer: b) Purchased by consumers.

2. The Retail Price Index (RPI) differs from the Consumer Price Index (CPI) because it includes: a) Mortgage interest payments b) Business investment c) Producer prices d) Government expenditure

   Answer: a) Mortgage interest payments.

3. Which inflation index is the primary indicator of consumer inflation in the UK? a) Consumer Price Index (CPI) b) Retail Price Index (RPI) c) Producer Price Index (PPI) d) Wholesale Price Index (WPI)

   Answer: a) Consumer Price Index (CPI).

4. The Producer Price Index (PPI) measures changes in the prices of goods and services at the: a) Consumer level b) Wholesale level c) Retail level d) Government level

   Answer: b) Wholesale level.

5. The Retail Price Index (RPI) is generally higher than the Consumer Price Index (CPI) because of the inclusion of: a) Taxes and duties b) Housing costs, such as mortgage interest payments c) Consumer durable goods d) Business investment

   Answer: b) Housing costs, such as mortgage interest payments.

Economics Essay 54: Inflation v Deflation

 “Deflation is more of a concern than inflation.” Discuss.

Certainly! Here's a comprehensive response that combines the differentiation between deflation and inflation, as well as an evaluation of why deflation is more concerning:

Deflation and inflation are two opposite phenomena that describe changes in the general price level of goods and services in an economy over time. Deflation refers to a persistent decrease in prices, while inflation refers to a sustained increase in prices.

While both deflation and inflation have their potential risks and challenges, deflation is generally more concerning than inflation due to the following reasons:

1. Impact on Economic Activity: Deflation can have severe consequences for economic activity. When prices consistently fall, consumers may delay purchases, anticipating further price decreases. This behavior, known as "hoarding," reduces consumer spending, which is a significant driver of economic growth. Reduced consumption leads to declines in business revenues, lower profits, reduced investment, and potentially job losses. For example, during the Great Depression, falling prices led to a significant decline in consumer spending, exacerbating the economic downturn.

2. Debt Burden: Deflation increases the real value of debt. As prices fall, the purchasing power of money increases, making it more difficult for borrowers to repay their debts. This situation can lead to a rise in loan defaults and financial instability, further dampening economic activity. The deflationary period in Japan during the 1990s, known as the "Lost Decade," resulted in increased bankruptcies and non-performing loans as individuals and businesses struggled with the rising burden of debt.

3. Negative Expectations: Deflation can create a deflationary mindset, where individuals and businesses expect prices to continue falling. This expectation can cause a further decrease in spending and investment, contributing to a downward spiral in economic activity. The Eurozone debt crisis provides an example where deflationary pressures led to consumers delaying purchases, waiting for even lower prices, weakening economic activity further.

4. Constraints on Monetary Policy: Deflation poses challenges for monetary policymakers. Central banks typically lower interest rates to stimulate borrowing and spending during deflationary periods. However, if interest rates are already near zero, known as the zero lower bound, further cuts become challenging. Japan's experience during the 1990s and early 2000s exemplifies this challenge, as the Bank of Japan struggled to combat deflation despite implementing aggressive monetary easing measures.

In contrast, inflation, when moderate, is generally considered less concerning than deflation. Moderate inflation can provide an incentive for consumers to make purchases and invest their money rather than holding onto it. Central banks also have a range of tools to address inflationary pressures, such as raising interest rates or implementing tighter monetary policy measures.

In conclusion, deflation is more concerning than inflation due to its adverse impact on economic activity, increased debt burden, negative expectations, and the constraints it places on monetary policy. Examples from history, such as the Great Depression and Japan's Lost Decade, highlight the detrimental effects of deflation on economies. Policymakers and central banks prioritize maintaining price stability and avoiding sustained deflationary pressures to support economic growth and stability.

Why do prices rise in capitalism?

 

Economics for Non Economists 5 – Inflation - Why is the government’s inflation rate lower than my personal experience?

By Girish Menon

Some of you would have realised that in the China virus season the supermarkets have raised prices and stopped offering discounts on many goods. As a result you would have experienced rising food bills which according to layman knowledge should translate into inflation*. At the same time, you may have read many economists predict a period of recession, deflation** and high levels of unemployment. So how is it that when you are experiencing inflation personally, economists predict the existence of deflation?

It all depends on the way the inflation rate is calculated.

The UK government uses the Consumer Price Index (CPI) to estimate the inflation rate in the British economy. It works like this:

1. Every year a few thousand families are asked to record their expenditure for a month. From this data the indexers estimate the types of goods and services bought by an average household and the quantity of their income spent on these goods.

2. With this information, surveyors are sent out each month to record prices for the above mix of goods. Prices are recorded in different areas of the country as well as in different types of retail outlets. These results are averaged out to find the average price of goods and this is converted into index numbers.

3. Changes in the price of some goods are considered more important than others based on the proportion of the income spent by the average household. This means that the above numbers have to be weighted before the final index is calculated. 

---Topics covered earlier

Relation between Debt and Profit

Explaining GDP and Economic Growth

Quantitative Easing

What is a Free Market

---

Consider this example:

Assume that there are only two goods in the economy, food and cars. The average household spends 75% of their income on food and 25 % on cars. Suppose there is an increase in the price of food by 8% and of cars by 4% annually.

In a normal average calculation, the 8% and 4% would be added together and divided by 2 to arrive at an average inflation of 6%

However, this provides an inaccurate figure because spending on food is more important in the household than spending on cars. Food is given a weight of 75% and cars are given a weight of 25%. So the price increase of food is multiplied by ¾ (8*3/4 = 6) and added to the price increase of cars which is multiplied by ¼ (4*1/4 =1) which will result in an inflation of 7%.

Therefore if the inflation index was 100 at the start of the year then it will read 107 at the end of the year.

The accuracy of inflation calculations

As the example makes clear this calculation is based on an imagined average family’s spending patterns. There maybe only a few families in the UK that have the exact same spending patterns as imagined by the government.

Theoretically, different rates of inflation could be calculated within an economy by changing the consumption patterns or weightings in the index. This will explain why the inflation that you experience may be higher or lower than the government’s inflation rate.

* Inflation is an average increase in price level compared over a previous period.

** Deflation is an average decrease in price level compared over a previous period.

Disinflation means the inflation in the current period is lower than the earlier period.

Crime, terrorism and tax evasion: why banks are waging war on cash

Paul Mason in The Guardian

Governments would love to see the end of banknotes. But what would a cashless society mean for freedom?

 

Will contactless payment help usher out cash? Photograph: Bloomberg/Bloomberg via Getty Images



I can remember the moment I realised the era of cash could soon be over.

It was Australia Day on Bondi Beach in 2014. In a busy liquor store, a man wearing only swimming shorts, carrying only a mobile phone and a plastic card, was delaying other people’s transactions while he moved 50 Australian dollars into his current account on his phone so that he could buy beer. The 30-odd youngsters in the queue behind him barely murmured; they’d all been in the same predicament. I doubt there was a banknote or coin between them.

The possibility of a cashless society has come at us with a rush: contactless payment is so new that the little ping the machine makes can still feel magical. But in some shops, especially those that cater for the young, a customer reaching for a banknote already produces an automatic frown.

Among central bankers, that frown has become a scowl. There is a “war on cash” in the offing – but it has nothing to do with boosting our ease of payment or saving trees.

Consider the central banks’ anti-crisis measures so far. The first was to slash interest rates close to zero. Then, since you can’t slash them below zero, the banks turned to printing money to stimulate demand. But with global growth depressed, and a massive overhanging debt, quantitative easing (QE) is running out of steam.

Enter the era of negative interest rates: thanks to the effect of QE, tens of billions held in government bonds already yield interest rates that are effectively below zero. Now, central banks such as Japan and Sweden have begun to impose negative official interest rates.

The effect, for banks or long-term savers, is that by putting your money in a safe place – such as the central bank or a government bond – you automatically lose some of it.

Not surprisingly, these measures have led to the growing popularity of cash for people with any substantial savings. Bank of England research shows demand for cash has grown faster than GDP in many countries. So the central banks face a further challenge: how to impose negative interest rates on cash itself.

Technologically, you can’t. If people hold their savings as physical currency, it keeps its value – and in a period of deflation the spending power of hoarded cash increases, even as share prices and the value of bank deposits fall. Cash, in a situation like this, is king.

But the banks are ahead of us. Last September, the Bank of England’s chief economist, Andy Haldane, openly pondered ways of imposing negative interest rates on cash – ie shrinking its value automatically. You could invalidate random banknotes, using their serial numbers. There are £63bn worth of notes in circulation in the UK: if you wanted to lop 1% off that, you could simply cancel half of all fivers without warning. A second solution would be to establish an exchange rate between paper money and the digital money in our bank accounts. A fiver deposited at the bank might buy you a £4.95 credit in your account.

More radical still would be to outlaw cash. In Norway, two major banks no longer issue cash from branch offices. Last month, the biggest bank, DNB, publicly called for the government to outlaw cash.

Why would a central bank want to eliminate cash? For the same reason as you want to flatten interest rates to zero: to force people to spend or invest their money in the risky activities that revive growth, rather than hoarding it in the safest place.

Calls for the eradication of cash have been bolstered by evidence that high-value notes play a major role in crime, terrorism and tax evasion.

In a study for the Harvard Business School last week, former bank boss Peter Sands called for global elimination of the high-value note. Britain’s “monkey” – the £50 – is low-value compared with its foreign-currency equivalents, and constitutes a small proportion of the cash in circulation. By contrast, Japan’s 10,000-yen note (worth roughly £60) makes up a startling 92% of all cash in circulation; the Swiss 1,000-franc note (worth around £700) likewise. Sands wants an end to these notes plus the $100 bill, and the €500 note – known in underworld circles as the “Bin Laden”.

The advantages of a digital-only payment system to the user are clear: you can emerge from the surf in only your bathing shorts and proceed to buy beer, food, or even a small car, providing your balance is positive. The advantages to banks are also clear. Not only can all transactions be charged a fee, but bank runs are eliminated. There can be no repeat of the queues outside Northern Rock, nor of the Greek fiasco last summer, because there will be no ATMs, only a computer spreadsheet moving digital money around. The advantages to governments are also clear: all transactions can be taxed. Capital controls are implicit within the system.

But there are drawbacks, even for governments that would like to take absolute control of money transactions. First, resilience. If a cyber-attack or computer malfunction took down a digital-only payment system, there would be no cash reserves in households and businesses to fall back on. The second is more fundamental and concerns freedom. In most countries, the ability to take your cash out of the bank and to spend it anonymously is associated with many pleasurable activities – not all of which are illegal but which exist on the margins of society. How tens of thousands of club-goers would pay for their drugs each Saturday night is a non-trivial issue.

Nevertheless, the arrival of negative interest rates for banks, together with new rules allowing governments to bail-in – ie confiscate – deposits above a protected minimum, are certain to increase savers’ awareness of the value of cash, and will prompt calls in earnest for its abolition.

If it happens, it would be the ultimate demonstration of the power of finance over people. As for resistance? Go ahead and try. It may be the Queen’s head on a £50 note but the “promise to pay” is made above the signature of a Bank of England bureaucrat.

Beware the great 2016 financial crisis, warns leading City pessimist

Larry Elliot in The Guardian

Albert Edwards joins RBS in warning of a new crash, saying oil price plunge and deflation from emerging markets will overwhelm central banks, tip the markets and collapse the eurozone.

 

Are the doommongers right – are we heading for a big global economic fall? Photograph: Dennis M. Sabangan/EPA

The City of London’s most vocal “bear” has warned that the world is heading for a financial crisis as severe as the crash of 2008-09 that could prompt the collapse of the eurozone.


Albert Edwards, strategist at the bank Société Générale, said the west was about to be hit by a wave of deflation from emerging market economies and that central banks were unaware of the disaster about to hit them. His comments came as analysts at Royal Bank of Scotland urged investors to “sell everything” ahead of an imminent stock market crash.

Sell everything ahead of stock market crash, say RBS economists



“Developments in the global economy will push the US back into recession,” Edwards told an investment conference in London. “The financial crisis will reawaken. It will be every bit as bad as in 2008-09 and it will turn very ugly indeed.”


Fears of a second serious financial crisis within a decade have been heightened by the turbulence in markets since the start of the year. Share prices have fallen rapidly and a slump in the cost of oil has left Brent crude trading at barely above $30 a barrel.

“Can it get any worse? Of course it can,” said Edwards, the most prominent of the stock market bears – the terms for analysts who think shares are overvalued and will fall in price. “Emerging market currencies are still in freefall. The US corporate sector is being crushed by the appreciation of the dollar.”

The Soc Gen strategist said the US economy was in far worse shape than the country’s central bank, the US Federal Reserve, realised. “We have seen massive credit expansion in the US. This is not for real economic activity; it is borrowing to finance share buybacks.”

Edwards attacked what he said was the “incredible conceit” of central bankers, who had failed to learn the lessons of the housing bubble that led to the financial crisis and slump of 2008-09.

“They didn’t understand the system then and they don’t understand how they are screwing up again. Deflation is upon us and the central banks can’t see it.”

Edwards said the dollar had risen by as much as the Japanese yen had in the 1990s, an upwards move that pushed Japan into deflation and caused solvency problems for the Asian country’s banks. He added that a sign of the crisis to come was the collapse in demand for credit in China.

“That happens when people lose confidence that policymakers know what they are doing. This is what is going to happen in Europe and the US.”

Europe has shown tentative signs of recovery in the past year, but Edwards said the efforts of the European Central Bank to push the euro lower and growth higher would come to nothing in the event of a fresh downturn. “If the global economy goes back into recession, it is curtains for the eurozone.”

Countries such as France, Spain and Italy would not accept the rising unemployment that would be associated with another recession, he said. “What a disaster the euro has been: it is a doomsday machine in favour of the German economy.”

The warning from Edwards came as stock markets had a respite from the wave of selling seen since the start of the year. The FTSE 100 index rose by 57 points to close at 5,929, while the Dow Jones Industrial Average was up by 10 points in early trading in New York.

The mood in equity markets was helped by intervention by the People’s Bank of China overnight to support the yuan, with the Chinese currency moving higher on foreign exchange markets.

But the slide in the oil price continued, with Brent crude falling a further 3.5% to close in London at $30.45. Oil has not been below $30 a barrel since 2003.

Edwards joked that after years in which he has tended to be a lone voice, other institutions were also becoming a lot gloomier about global prospects.

He was referring to the RBS advice, which warned that investors face a “cataclysmic year” where stock markets could fall by up to 20% and oil could slump to $16 a barrel.

In a note to its clients the bank said: “Sell everything except high-quality bonds. This is about return of capital, not return on capital. In a crowded hall, exit doors are small.” It said the current situation was reminiscent of 2008, when the collapse of the Lehman Brothers investment bank led to the global financial crisis. This time China could be the crisis point, RBS said.