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Topic 3.4
Price Stability
Begin this topic by learning about AD/AS curves, and then find out about how price levels change through inflation, deflation and disinflation. You will also learn how we measure inflation using the Consumer Price Index.
AD/AS curves
Aggregate Demand (AD)
Aggregate Demand (AD) represents the total demand for goods and services within an economy at a given overall price level and in a given time period. It is composed of consumption, investment, government spending, and net exports (X-M). AD can be drawn on a graph and looks like a normal demand curve - it only shifts when one of the four factors increases. Remember that if imports increase AD shifts left.
NB: AD/AS curves are labeled with PL (price level) on the y-axis and RGDP (real GDP) on the x-axis, with Y and P used for labelling.
Aggregate Supply (AS)
Aggregate Supply (AS) measures the total quantity of goods and services that suppliers are willing and able to produce and sell to the market at a given price level. In the short run (SRAS), the curve is typically upward sloping as higher prices encourage more production. In the long run (LRAS), the curve is often represented as a curve that is elastic at the bottom as there is high spare capacity (unused FoPs) but inelastic at the top due to using all of the economy's FoPs.
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LRAS only shifts when there is a change in the quantity or quality of the factors of production
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SRAS only shifts when costs of production change
NB: SRAS is not needed at GCSE
Price Stability and Inflation
Price Stability
When the general price level stays constant or grows at an acceptably low rate (Bank of England's target is 2%).
General Price Level
A measure of overall average price level of goods and services in an economy at a particular point in time
Cost of Living
The price level of goods and services bought by the average family
Inflation
A sustained rise in the general price level over time, causing a decrease in the purchasing power of money
Rate of Inflation
The percentage rise in the general price level over time - the BoE's target is 2% ± 1%
Common Misconceptions
A common mistake is confusing disinflation with deflation. Disinflation means prices are rising more slowly than before but inflation is still occuring, whereas deflation means prices are actually falling. It is also important to remember that a target inflation rate (usually 2%) is often preferred over 0% or negative rates as it encourages stable spending and investment. The Bank of England's Target is 2%±1%
Measuring Inflation: The Consumer Price Index
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The Consumer Price Index (CPI) is the UK’s most widely used measure of inflation.
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It tracks how the prices of a representative basket of around 700 goods and services change over time, which reflects what the average household typically buys.
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Each item is weighted according to how important it is in a typical household budget. For example, petrol has a higher weight because it is a major household expense.
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The Office for National Statistics measures the prices in the basket each month. These prices are compared with a base month, which is set to 100.
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If the CPI rises from 100 to 102, that means prices have increased by 2%, showing 2% inflation.
Comparing Inflation: Real and Nominal Values
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Understanding the difference between nominal and real values is important for making accurate economic comparisons.
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Nominal values are measured in current prices and do not adjust for inflation.
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Real values are adjusted for changes in the price level, so they show the true change in purchasing power or output over time.
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Because they remove the effect of inflation, real values are better for comparing economic data across different time periods.
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For example, if you save £100 and earn 2% interest, your balance rises to £102 nominally. But if inflation is also 2%, the extra £2 does not increase your purchasing power. So your real interest rate is 0%.
Types of Inflation
Demand-Pull Inflation
Demand-pull inflation occurs when the total demand for goods and services in an economy exceeds the economy's output capacity. This 'excess' demand pulls up prices as consumers compete for limited supply. This occurs when AD shifts left.
Cost-push inflation
Cost-push inflation happens when the costs of production (like wages or raw materials) increase for firms. To maintain profit margins, firms raise the prices of their goods and services, pushing inflation higher. This occurs when SRAS shifts left, and it can cause a wage-price spiral
Wage-Price Spiral
Prices increase, reducing the real value of workers' wages.
Workers demand higher wages to maintain their living standards. This happens with help of trade unions
Firms grant higher wages, increasing their costs of production.
Firms raise consumer prices to protect their profits.
SRAS shifts left and inflation (cost-push) occurs. Prices rise.
Evaluating the impact of inflation on individuals
Points
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The purchasing power of money decreases, which means that they can buy less goods and services with the same amount of money. This is bad, because they are then forced to spend a lot of time browsing. This is because they are unsure about the market, and need to find cheaper substitutes, or just the cheapest place to buy from, to try to save money. This is known as shoe leather costs. This has an opportunity cost, as the time spent looking for better alternatives could have been spent more productively.
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The purchasing power of money decreases, which means that they can buy less goods and services with the same amount of money. This is bad, because if their nominal incomes remain the same and inflation occurs, then their real incomes will fall. After taxes and national insurance, their disposable income will be much lower than previously, which means that they can consume less.
Evaluations
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However, these effects of shoe leather costs are only present at high levels of inflation, not at a smaller level that we experience typically. This means that the effect on prices won’t be as significant, unless there is double-digit or galloping inflation.
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However, consumers can use trade unions, who will use collective bargaining to get improved wages.This will mean that their real income will not take a cut, and their consumption will not decrease - they will still be able to buy the same number of goods as before. Some trade unions that have more power can bargain for wages that will take into account future projected inflation. This leads to people getting higher wages than previously, which can actually increase their living standards. Wage price spiral - can actually make more money
Evaluating the impact of inflation on savers
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Reduces the value of savings - Inflation means that the interest paid on savings accounts was less than the rate of inflation, so savers could buy less with their money over time. As a result, the purchasing power of savers fell, which may discourage people from saving in the future. This can also mean that people who rely on savings for income, such as pensioners, are worse off.
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Inflation can benefit borrowers because it reduces the real value of the money they repay over time. If wages and prices rise, fixed loan payments become easier to afford.
Evaluations
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Interest rates might rise to reduce inflation - Raising interest rates can help savers during inflation because savings accounts often pay more, helping money keep up with rising prices. This protects some of your purchasing power.
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This benefit for borrowers may not last if the central bank raises interest rates to control inflation. Higher interest rates increase the cost of borrowing, so people with variable-rate mortgages may see their repayments rise. Also, if wages do not increase in line with inflation, borrowers may still struggle to afford higher repayments and other living costs.
Evaluating the impact of inflation on governments
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Due to the wage price spiral of inflation, the wages of workers in the economy will rise due to inflation. This is because their trade unions will use collective bargaining, and get a higher wage for those workers, in order to compensate for the price increases. Without this, they would have a real wage cut and would be able to consume less. The government is a major employer of workers through institutions such as the NHS, so these wage increases would mean that they would have to spend significantly more, which can create a budget deficit - the government may have to raise taxes to cope.
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The government will have to spend more on benefits (so that the real value of benefits don’t fall). This will also contribute to the government spending, and add to the budget deficit.
Evaluations
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The government will get an increase in tax revenue from income tax, which may be able to cover the spending increase. This is because the increase in wages across the country will require an increase in income tax. Corporation tax and VAT will also increase as the general price level has increased. However, it is difficult to know whether or not it will cover for the budget deficit created.
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They gain as a debtor as the value of debt decreases, and they could try using supply-side policies so that in the long-run less benefits need to be payed