Inflation, the CPI and monetary policy

Last time

Before we start: last time, in Economic growth and recession, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

When prices keep rising

Ask anyone what a kilo of flour cost five years ago. It cost less. When the prices of most goods keep rising, money buys less each year. That is inflation. In this lesson: how it is measured, what causes it, who it hurts, and how the central bank fights it.

What inflation is

Inflation is a sustained rise in the general price level. Not one price rising once, but most prices rising over time. As prices rise, the purchasing power of money falls: each rupee buys less. Deflation is the opposite: a sustained fall in the general price level.

The consumer prices index

Inflation is measured with a consumer prices index, the CPI. A survey finds what a typical household buys: this is the basket of goods and services. The prices of the basket are checked regularly. Each item is given a weight, by how much of their income households spend on it. A base year is set at 100. If the index is 108 a year later, prices have risen by 8 per cent on average.

Weights, worked

Suppose households spend 60 per cent on food and 40 per cent on transport. Food prices rose to an index of 110, transport to 105. The weighted index is 0.6 times 110, plus 0.4 times 105: 66 plus 42, which is 108. Inflation is 8 per cent.

Demand-pull inflation

Demand-pull inflation happens when total demand grows faster than the economy's output. If households spend more, firms cannot raise output fast enough, so goods run short and firms raise prices. Causes include rising incomes and confidence, lower interest rates, tax cuts, more government spending and rising exports.

Cost-push inflation

Cost-push inflation happens when firms' costs rise and they pass them on as higher prices. Higher wages, higher prices of oil and raw materials, and higher indirect taxes all push costs up. A fall in the exchange rate makes imported raw materials dearer, which also pushes costs up.

Who loses from inflation

People on fixed incomes, such as pensioners, lose, because their income buys less. Savers lose if interest rates are below inflation. Exports become less competitive if prices rise faster than abroad, and uncertainty makes firms delay investment. Firms face costs of changing prices. Borrowers may gain, because the money they repay is worth less.

The problem with deflation

If people expect prices to keep falling, they delay buying, waiting for lower prices. So firms sell less, cut output and jobs, and unemployment rises. And debts become harder to repay, because money is worth more.

Monetary policy

Monetary policy is the use of interest rates, the money supply and the exchange rate to influence the economy. It is run by the central bank. Fiscal policy is different: it uses government spending and taxes. And supply-side policy aims to raise productive capacity, through education, training and competition.

Raising interest rates

A rise in the interest rate makes borrowing dearer and saving more rewarding. So households and firms spend less, total demand falls, and inflation slows. The higher rate may also raise the exchange rate, making imports cheaper.

Will a cut in interest rates cut inflation?

Usually not. A cut makes borrowing cheaper and saving less rewarding, so spending rises, which can raise demand-pull inflation. It might in one case: if inflation is cost-push, cheaper loans can cut firms' costs and help them raise output. And it may weaken the currency, raising import prices. So most economists expect a cut to raise inflation.

Other ways to control inflation

Fiscal policy: raise taxes or cut government spending, to reduce total demand. Supply-side policy: raise productivity, so output grows faster and costs fall. Match the policy to the cause: demand-pull needs demand cut; cost-push needs costs cut.

Mistakes that lose marks

Mistake one: defining inflation as high prices. It is a sustained rise in the general price level. Mistake two: describing the CPI as a list of supermarket prices. It is a weighted basket, with a base year. Mistake three: saying higher interest rates reduce inflation, with no chain in between. The fix: rise, general, sustained; basket and weights; and the full chain.

The full-marks tip

The full-marks tip: define inflation with the words sustained and general price level. For monetary policy, write the full chain: rate, borrowing and saving, spending, demand, prices.

On one card

So, on one card: inflation and monetary policy. Keep it for revision.