Inflation is defined as a sustained increase in the average price level within an economy, primarily measured by the Consumer Price Index (CPI) with a targeted rate of 2% in the UK. Causes of inflation include demand-pull, where excess demand leads to price increases, and cost-push, resulting from rising production costs. Inflation has various impacts, including eroding purchasing power, affecting savings and wages, and potentially leading to higher unemployment and economic instability.

1. Inflation

2. What is inflation?
Inflation is a
sustained
increase in the
average price
level of an
economy

3. How inflation is measured
• The rate of inflation is measured by
the annual percentage change in the
level of prices as measured by the
consumer price index
• A sustained fall in the general price
level is called deflation – in this
situation, the rate of inflation
becomes negative

4. Consumer Price Index (“CPI”)
• The consumer price index is the main
measure of inflation for the UK
• The government has set the Bank of
England a target for inflation (using the CPI)
of 2%
• The aim of this target is to achieve a
sustained period of low and stable inflation
• Low inflation is also known as price stability

5. Recent CPI Inflation in the UK

6. Inflation (CPI) and Interest Rates
Interest rates are used by the Bank of
England as a key weapon to control
inflation. The Base Rate fell to a low of
0.5% in 2009 as fears of prolonged
recession grow stronger

7. Two main causes of inflation
Demand pull Cost push
When there
When costs
is excess
rise
demand

8. Demand Pull Inflation
• Occurs when there is excess aggregate
demand in the economy or market
• Businesses respond to high demand by
raising prices to increase their profit
margins
• Demand-pull inflation is associated with
the boom phase of the business cycle

9. Possible causes of demand pull inflation
• A depreciation of the exchange rate increases the
price of imports and reduces the foreign price of UK
exports
• A reduction in direct or indirect taxation - consumers
have more disposable income causing more demand
• Rising consumer confidence and an increase in the
rate of growth of house prices
• Faster rates of economic growth in other countries –
providing a boost to UK exports overseas

10. Cost Push Inflation
• Occurs when costs of production are increasing
• Causes:
– External shocks (e.g. commodity price fluctuations)
– A depreciation in the exchange rate
– Acceleration in wages
• What happens?
– Firms raise prices to protect their profit margins – better able to
do this when market demand is price inelastic
– “Wages often follow prices”
– A rise in inflation can lead to rising inflationary expectations

11. E.g. cost push inflation and oil prices
UK Inflation and Crude Oil Prices
Annual percentage change in the Consumer Price Index and monthly average for Brent Crude
140 140
120 120
100 100
USD/Barrel
80 80
Crude Oil Price
60 60
40 40
20 20
0 0
5.5 5.5
5.0 5.0
4.5 4.5
4.0 4.0
Consumer Price Inflation
3.5 3.5
Percent
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
00 01 02 03 04 05 06 07 08 09
Source: UK Statistics Commission and IPE

12. Inflation - Costs and Consequences (1)
• Money loses its value and people lose confidence
in money as the value of savings is reduced
• Inflation can get out of control - price increases
lead to higher wage demands as people try to
maintain their living standards. This is known as a
wage-price spiral.
• Consumers and businesses on fixed incomes lose
out because the their real incomes falls -
employees in poor bargaining positions lose out

13. Inflation - Costs and Consequences (2)
• Inflation can favour borrowers at the expense of savers
– because inflation erodes the real value of existing
debts
• Inflation can disrupt business planning and lead to
lower capital investment
• Inflation is a possible cause of higher unemployment in
the long term – because of a lack of competitiveness
• Rising inflation is associated with higher interest rates -
this reduces economic growth and can lead to a
recession

14. Business effects of inflation (1)
Industry-wide price rises
Some enable revenues to grow
Growing revenues +
inflation is constant gross margin =
higher gross profit
good for Makes using debt as a
business! source of finance cheaper
in real terms

15. Business effects of inflation (2)
Effect of inflation on
revenue?
What is the price elasticity of
demand for the product?

16. Price elasticity of demand
• Refers to the responsiveness of demand
to changes in price
• When demand is elastic, a price rise
leads to a more than proportionate fall
off in quantity demanded
• When demand is inelastic, a price rise
leads to a less than proportionate fall
off in quantity demanded

17. Price elasticity
• Firms with inelastic price elasticity of
demand will be less affected by a rise in
inflation
• Some firms will be able to absorb price
increases by becoming more efficient
• Price inflation will vary from industry to
industry – be careful about making
generalisations

18. Inflation and business costs
• A rise in general inflation:
– Sales revenue should rise
– But workers likely to demand higher pay to
compensate for consumer price inflation
– Labour intensive industries more at risk
• Input cost inflation
– Cost-push inflation will vary from industry to
industry
– Firms that need to buy significant commodity raw
materials may find profit margins squeezed if they
cannot pass on increased costs to customers

19. Expectations of inflation
• Expectations of inflation are important in
shaping what actually happens to inflation!
• When people see prices are rising for the
everyday items they purchase they start to
get concerned about the effects of inflation
on their standard of living
• An initial rise in prices triggers higher pay
claims as workers look to protect their way
of life

20. What is Deflation?
• Deflation is a period when the general
price level falls
• Normally associated with a significant
reduction in economic activity
(depression / slump)
• Can also occur if the economy is rapidly
building its productive potential

21. Economic & business costs of deflation
• Consumer postpone spending – if they
believe prices will go lower (= reduction
in demand)
• The real value of debt increases – makes
it harder to pay debt off
• Falling asset prices (e.g. housing)
• Business profit margins fall (lower selling
prices)

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