1) Define the term 'inflation'
Inflation is a measure of the increase in the general price level, resulting in money losing its buying power and therefore its value.
2) In which of the following situations is an economy suffering from disinflation?
The annual rate of inflation is falling from 4% to 2.5%
3) Explain why economists might be interested in the UK's core inflation rate.
The core inflation rate removes the products who's prices are volatile to fluctuate based on supply and demand such as oil and food. This allows economists to see the general trend of the general price level change within an economy more clearly.
4) In which of the following situations is an economy suffering from deflation?
The annual rate of inflation is at a constant -2%
5) Explain why governments try to avoid periods of deflation.
Deflation means that money is gaining value and purchasing power as the general price level falls. This may cause people to choose to delay purchases to the future as the think that they will be cheaper later on. This causes economies to stammer/shrink as consumption expenditure falls and as consumption expenditure is a factor of aggregate demand, aggregate demand also falls. (which would be illustrated by the AD curve shifting to the left). This would result in firms reducing production which means they would need less workers therefore people would lose their jobs and the unemployment rate would rise dramatically.
6) Which of the following is an example of demand-pull inflation?
A- A rise in consumer confidence and the level of consumption.
7) Explain how a depreciation in the value of the pound might result in demand-pull inflation.
A depreciation in the value of the pound means that it is worth less in the national economy. This causes imports to the UK to be more costly and therefore the amount of imports will decrease. It will also decrease the price of UK exports which means the demand for them increases. As these are both factors of Aggregate demand, rising exports and falling imports will boost aggregate demand. An increase in aggregate demand when the UK's economy is almost working at its maximum capacity means that demand is higher than the available supply. This can cause steep inflation of prices and is know as demand-pull inflation as the rise in demand "pulls" up the general price level.
8) Explain the effects of a sustained fall in real wages, such as that experienced in the UK recently, on the rate of inflation.
A sustained fall in the wages of workers means that firms production costs fall as labour is a factor of production, causing the quantity supplied at each price level to increase. This causes the aggregate supply curve to shift to the right (in the short run). This causes an expansion along the aggregate demand curve meaning real national output is expanding and the general price level is falling. This would decrease the inflation rate and possibly even cause the economy to move into deflation.
Another effect of sustained decrease in real wages would be a decrease in consumers confidence as they worry about their financial stability in the future. This means they may postpone purchases as they chose to save money, causing a decrease in consumption and investment expenditure. As both of these forms are key factors of aggregate demand, a decrease in them will cause a decrease in aggregate demand causing a shift to the left. This causes a contraction along the aggregate supply curve which pulls down price levels. This will cause price levels to fall which can cause deflation or at least decrease the inflation rate.
9) Explain why changes in the prices of commodities such as wheat and oil have a significant impact on the rate of inflation in the UK.
Wheat and oil combined make up a significant of total imports to the UK at over 20%. These raw materials are used in many industries, for example wheat is used to make pasta and animal feed, oil is used in power stations and manufactured into plastics therefore we are quite dependent on them and there aren't any close substitutes. This makes the UK quite vulnerable to commodity price changes. Due to the cost-push inflation mechanism, an increase in the cost of raw materials and therefore the costs of production will increase the general price level, otherwise known as inflation. A similar but opposite effect happens if the commodity prices fall, causing production costs to fall and therefore the general price level to fall, otherwise known as deflation.
10) Explain the possible effects of the growth of emerging economies such as China and Brazil on the rate of inflation in the UK.
As economies such as China and Brazil begin to grow they begin to demand larger quantities of global commodities which are also demanded by the UK. This increased demand depletes limited resources further. This competition and shortage means that suppliers can increase prices, meaning that the production costs in the UK will rise, forcing firms to increase the prices of products, which is inflation.
However, the emerging economies can also lower inflation in the UK. For example in China they have a huge cheap labour force which allows them to keep the price of manufactured goods relatively low. This means keeps inflation rates low as retailers of the products aren't forced to charge higher prices for the products.
