Costs And Effects Of Inflation

Inflation measures the annual rate of change of the general price level in the
economy. Inflation is a sustained increase in the average price level over a given
period of time.
In the United Kingdom, the main measure of inflation is done through the Retail
Price Index. The Retail Price Index (RPI) measures the average change in prices
of a sample of over 600 goods and services that an “average” family purchases.
Remember index numbers are a simple way of showing large complex numbers.
The first piece of data is given a value of 100, and all subsequent values are then
easily compared with that value of a 100.
It is a weighted index, which means that a change in price of a good affects
inflation more, if we spend a greater proportion of our income on it. (and a large
change in price of a good we spend very little of our income on will hardly change
the retail price index)
The Main Causes Of Inflation
This is where the money supply in the economy increases at a faster rate than
output and so it is too much money chasing too few goods. This is closely related
There is too much demand chasing too few goods, therefore firms realise they
can put up their prices.
Main causes of demand pull inflation:
 Rapid growth of household income and therefore consumption
 Increases in government spending
 Increased demand from higher exports
This occurs when firms increase prices to maintain or protect profit margins after
experiencing a rise in their costs of production.
The main causes are:
 Growth in Unit Labour Costs
 Rising input costs
 Increases in indirect taxes
 Higher import prices (Imported inflation)
Costs And Effects Of Inflation
Effect on competitiveness - if a country has higher inflation than the rest of
the world it will lose price competitiveness in international markets.
The problems of a wage-price spiral – price rises can lead to higher wage
demands as workers try to maintain their real standard of living. Higher
wages can cause an increase in costs. To maintain their profit margins
firms increase prices. The process could start all over again and inflation
may get out of control.
Consumers and businesses on fixed incomes will lose out. Many
pensioners are on fixed pensions so inflation reduces the real value of their
income year on year, this means that their demand for goods and services
will be reduced.
However workers in Trade unions and others with a strong bargaining
position are less affected by inflation as they can negotiate wage increases
which may mean that their real wages do not fall.
Inflation can also cause a disruption of business planning – uncertainty
about the future makes planning difficult and this may have an adverse
effect on expansion plans and so reduce economic growth.
Savers lose out with inflation as the real value/purchasing power of their
savings fall
However borrowers benefit from inflation as the real value of their debts is
actually reduced by inflation.
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