2.1.2a Measuring inflation

Inflation and deflation

1. Inflation erodes the purchasing power of money: at 5% inflation, £100 buys only what about £95 bought a year earlier.
2. Deflation is rarer but damaging: Japan suffered mild but persistent deflation from the late 1990s, and falling prices led households to delay spending, which held back demand and growth.

The CPI basket

$$CPI=\sum w_i{p}_i,\sum w_i=1$$

1. The ONS collects around 180,000 prices each month for a basket of roughly 700 goods and services.
2. Each item is weighted by its share of spending, and the basket is revised annually so it stays representative as habits change.

Index numbers

$$inflation\; rate=\frac{{CPI}_t-{CPI}_{t-1}}{{CPI}_{t-1}}\times 100\%$$

1. The rate of inflation is the percentage change in the index over twelve months.
2. An index of 103 means prices are 3% above the base year, not that the basket costs £103.

CPI limitations and RPI

1. The basket can lag changes in spending habits, and it is hard to adjust fully for improvements in quality.
2. A single national index does not fit every household, because spending patterns differ across income groups and regions.
3. The RPI includes mortgage interest and other housing costs, so it usually reads a little higher than the CPI.

2.1.2b Causes and effects of inflation

Causes of inflation

1. On an AD/AS diagram, demand-pull is a rightward shift of aggregate demand that raises the average price level.
2. Cost-push is a leftward shift of short-run aggregate supply, driven by higher wages or imported costs such as energy.

Monetary causes

1. When the money supply grows faster than output can, spending outstrips the goods available and prices are bid up.
2. Expectations of higher prices feed through into wage demands and can become self-fulfilling.

Effects of inflation

1. Inflation erodes the real value of money and redistributes income between economic agents.
2. Consumers lose purchasing power if their incomes rise more slowly than prices.
3. Workers press for higher wages to protect their real pay, which can add to cost-push pressure.
4. In extreme cases the costs become catastrophic: in Zimbabwe in 2008 and in Weimar Germany in 1923, hyperinflation running into millions of percent destroyed the value of money so fast that it stopped working as a store of value or medium of exchange.

Winners and losers

1. Firms face menu costs and greater uncertainty, which can deter investment and weaken international competitiveness.
2. The government gains revenue through fiscal drag but pays more on index-linked benefits and debt.
3. Savers and lenders lose as the real value of money falls, whereas borrowers gain as the real value of their debt shrinks.
4. The scale of these effects depends on whether the inflation is anticipated and on how high the rate is:

$$real\; interest\; rate\approx nominal\; interest\; rate-inflation$$

Is inflation always harmful?

1. It holds because high or accelerating inflation erodes purchasing power and creates uncertainty that deters investment and worsens competitiveness, hurting most agents.
2. But low, stable and anticipated inflation around the 2% target does little damage and is preferred to deflation, which can trap an economy in falling demand and delayed spending.
3. But the effects are uneven: borrowers and the government can gain while savers and those on fixed incomes lose, so inflation redistributes rather than simply destroying value.
4. On balance, whether inflation is harmful depends on its rate, whether it is anticipated, and how quickly wages and interest rates adjust.