Inflation is a sustained increase in the average price level of an economy.
- 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
Consumer Price Index (CPI)
- the consumer price index is the mean 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
Two main causes of inflation
Demand pull
- when there is excess demand
Cost push
- when costs rise
Inflationary case study: https://www.bbc.co.uk/news/business-12196322
Main causes of demand pull inflation
- Very fast growth of demand for credit/borrowing
- High levels of consumer spending
Deflation
- A period when general price levels fall
- Normally associated with a significant reduction in economic activity (depression/slump)
- Can also occur if the economy is rapidly building its productive potential
Economic & Business costs of deflation
- Consumers postpone spending if they believe prices will go lower
- The real value of debt increases and makes it harder to pay debt off
- Falling asset prices (such as housing)
- Business profit margins fall due to lower selling prices
Some inflation is good for business
Effect of inflation on revenue
- The price elasticity of demand is an important factor in how inflation will impact revenue
- If the product is price elastic, then revenue is likely to fall during inflation
- If the product is price inelastic, then revenue will not change much during inflation
- Price elasticity of demand refers to the responsiveness of demand to changes in price
Inflation and business costs
- A rise in general inflation:
- Sales revenue should rise
- But workers are more likely to demand higher pay to compensate for consumer price inflation
- Labour intensive industries at more 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