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.

Economists draw swords over how to tackle Inflation

For as long as inflation has been high economists have fought about where it came from and what must be done to bring it down. Since central bankers have raised interest rates and headline inflation is falling, this debate may seem increasingly academic. In fact, it is increasingly important. Inflation is falling mostly because energy prices are down, a trend that will not last for ever. Underlying or “core” inflation is more stubborn (see chart 1). History suggests that even a small amount of sticky underlying inflation is hard to dislodge.




So the chiefs of the world’s most important central banks are now warning that their job is far from done. “Getting inflation back down to 2% has a long way to go,” said Jerome Powell, chairman of the Federal Reserve, on June 29th. “We cannot waver, and we cannot declare victory,” Christine Lagarde, president of the European Central Bank, told a meeting of central bankers in Portugal just two days earlier. Andrew Bailey, governor of the Bank of England, recently said that interest rates will probably stay higher than markets expect.

This means there will be no let-up in the economists’ wars. The first front is partly ideological, and concerns who should shoulder the blame for rising prices. An unconventional but popular theory suggests greedy firms are at fault. This idea first emerged in America in mid-2021, when profit margins for non-financial companies were unusually strong and inflation was taking off. It is now gaining a second wind, propelled by the imf, which recently found that rising profits “account for almost half the increase” in euro-zone inflation over the past two years. Ms Lagarde appears to be entertaining the thesis, too, telling the European Parliament that “certain sectors” had “taken advantage” of the economic turmoil, and that “it’s important that competition authorities could actually look at those behaviours.”

Greedflation is a comforting idea for left-leaning types who think the blame for inflation is too often pinned on workers. Yet it would be strange to think firms suddenly became more greedy, making prices accelerate. Inflation is caused by demand exceeding supply—something that offers plentiful profit opportunities. The greedflation thesis “muddles inflation’s symptoms with its cause”, according to Neil Shearing of Capital Economics, a consultancy. Wages have tended to play catch-up with prices, not vice versa, because, as the imf’s economists note, “wages are slower than prices to react to shocks”. That is a crucial lesson from today’s inflationary episode for those who always view economic stimulus as being pro-worker.

The second front in the inflation wars concerns geography. America’s inflation was at first more homegrown than the euro zone’s. Uncle Sam spent 26% of gdp on fiscal stimulus during covid-19, compared with 8-15% in Europe’s big economies. And Europe faced a worse energy shock than America after Russia invaded Ukraine, both because of its dependence on Russian natural gas and the greater share of its income that goes on energy. A recent paper by Pierre-Olivier Gourinchas, chief economist at the imf, and colleagues attributes just 6% of the euro zone’s underlying inflation surge to economic overheating, compared with 80% of America’s.

This implies that Europe can get away with looser policy. The 3% of gdp of extra fiscal stimulus the euro zone has recently unleashed by subsidising energy bills, the authors find, has not contributed to overheating, and by reducing measured energy prices may even have stopped an inflationary mindset from taking hold. (The authors caution that things might have been different had energy prices not fallen, reducing the subsidy.) Interest rates are lower in Europe, too. Financial markets expect them to peak at around 4% in the euro zone, compared with 5.5% in America.


Despite all this, inflation problems on each side of the Atlantic actually seem to be becoming more alike over time. In both places, inflation is increasingly driven by the price of local services, rather than food and energy (see chart 2). The pattern suggests that price rises in both places are being driven by strong domestic spending. Calculated on a comparable basis, core inflation is higher in the euro zone. So is wage growth. According to trackers produced by Goldman Sachs, a bank, wages are growing at an annualised pace of 4-4.5% in America, and nearly 5.5% in the euro area.

Hence the importance of a final front: the labour market. Even if profit margins fall, central banks cannot hit their 2% inflation targets on a sustained basis without the demand for and supply of workers coming into better balance. Last year economists debated whether in America this required a higher unemployment rate. Chris Waller of the Fed said no: it was plausible job vacancies, which had been unusually high, could fall instead. Olivier Blanchard, Alex Domash and Lawrence Summers were more pessimistic. In past economic cycles, they pointed out, vacancies fell only as unemployment rose. Since then Mr Waller’s vision has in part materialised. Vacancies have fallen enough that, according to Goldman, the rebalancing of the labour market is three-quarters complete. Unemployment remains remarkably low, at 3.7%.

Yet the process seems to have stalled of late (fresh data were due to be released as we published this article). Mr Blanchard and Ben Bernanke, a former Fed chairman, recently estimated that, given the most recent relationship between vacancies and joblessness, getting inflation to the Fed’s target would require the unemployment rate to exceed 4.3% for “a period of time”. Luca Gagliardone and Mark Gertler, two economists, reckon that unemployment might rise to 5.5% in 2024, resulting in inflation dropping to 3% in a year and then falling towards 2% “at a very slow pace”.

Rises in unemployment of such a size are not enormous, but in the past have typically been associated with recessions. Meanwhile, in the euro zone, vacancies have not been particularly elevated relative to unemployment, making the route to a painless disinflation even more difficult to see. It is this front of the inflation wars which is most finely poised—and where the stakes are highest.

A dispatch from the intellectual battlefield in The Economist