In-depth summary covering the knowledge required under the OCR A level economics specification. Includes a number of analysis and evaluative points to assist students with essay-based questions.
Inflation
Inflation: when there is a sustained rise in the general price level in an economy over time. It is also
defined as a fall in the purchasing power of money - more money is needed to buy te same quantity of
goods and services so the cost of living has gone up.
Deflation: A fall in the general price level (negative inflation)
Disinflation: This is a fall in the rate of inflation - although prices are still rising, they rise at a lower
rate. Inflation is decelerating.
Hyperinflation: a situation in which inflation reaches extreme excessive rates - inflation is completely
out of control. Generally when the prices of goods and services rise more than 50% per month. This
has been experienced in countries such as Venezuela and Zimbabwe
Real vs Nominal values: The nominal value is the current value without taking inflation or other
market factors into account - it is essentially the face value of a good. The real value is the nominal
value after it has been adjusted for inflation - tales into account the prices of other market values.
Justification for the 2% Inflation target: 2% inflation target allows the economy to grow and
sustains an adequate level of AD in the economy - encourages current consumption to take place
while also allowing firms and consumers to make accurate predictions about future investments.
Inflation:
Causes:
● Demand - Pull inflation: This is inflation initiated by an increase in aggregate demand - this
can be triggered by an increase in any of the components of AD:
○ A cut in interest rates which reduces the cost of borrowing and the rate of return on
savings - also reduces monthly payments for those on variable or tracker mortgages.
○ A reduction in the marginal rate of income tax for those in lower income tax banks or
increase income free tax allowance (higher MPC for those low-income consumers)
○ Expansionary fiscal policy - reduction in tax e.g. corporation taxes, boost in govs
pending
○ Weakened exchange rate: increases net exports
● Cost - Push inflation: This is inflation initiated by an increase in the costs faced by firms,
arising on the supply side of the economy - a decrease in SRAS:
○ Increases in raw material/commodity prices such as oil which impacts many firms
across the economy
○ Wage increases: one of the greatest costs of production of business - a rise in wages
due to higher min wages, growing TU strength or anticipated inflation will increase
COPs which is passed onto higher prices.
○ Indirect taxes like a VAT increase
○ Weak exchange rate - makes imports more expensive so costs of imported raw
materials increases.
, ● Growth in the money stock (quantity of money in the economy) - although there could be
one-off movements in AD or AS which lead to one-off changes in the price level, persistent
inflation can take place only when the money stock grows more rapidly than real output - if
this happens then firms and households find that they have excess cash balances (at a given
price level they have more purchasing power than they expected to have) which means that
they will increase spending causing an increase in AD. they will also save some excess which
tends to result in lower interest rates reinforcing the increase in AD. However when AD
increases the price level will rise again, so inflation will only continue if the money supply
continues to increase and the process repeats itself.
Consequences:
Costs:
● Savings are eroded in value: savings that are meaning a rate of return less than the inflation
rate are falling in real value - this may reduce the incentive to save and thus reduce the
loanable funds for banks to issue businesses for investment purposes which depresses SR
and LR economic growth.
● Uncertainty in Investment: It becomes difficult for firms to predict future prices and interest
rates which means they become uncertain on the future return on investments. Firms may
become reluctant to undertake investment which prevents an expansion on the economy’s
productive capacity and means that there is still high pressure on existing resources so
inflation continues.
● Fiscal Drag: workers receive a pay increase to match inflation but are pushed into a higher
income tax band which is not adjusted for inflation - in real terms the individual is no better off
and this could reduce the incentives for individuals to earn higher incomes if tax bands are not
adjusted in accordance with inflation.
● Reduced international competitiveness: as inflation increases, the competitiveness of
domestic exports decreases which reduces the demand for them and the revenues generated
from them. Imports become relatively cheaper which worsens the current account deficit as
net exports fall. A low inflation rate helps to keep an economy's goods and services price
competitive internationally
● Resource Allocation / inflationary noise: Inflation distorts the ability of prices to act as signals
so there is a wastage of resources and lost business opportunity - prices act as signals in the
economy regarding the relative scarcity of a given product, if inflation is high and volatile
businesses are unable to interpret price changes of goods and services which creates
uncertainty in the economy. This also creates a money illusion where rising prices lead people
to make irrational decisions - for example if wages rise workers may decide to work longer
hours however they have no gain in real incomes as the inflation has eroded the value of their
wage increases.
● Effects on Wages: as prices rise workers will negotiate for higher wages to keep real wages
the same as they see their purchasing power fall.This causes the COPs for firms to rise so
their raise prices to maintain their prices which reinforced inflation (this is the price wage
spiral) - anticipates inflation means workers bargain for higher wages to compensate for
increased prices.
● Anticipated inflation: rational consumers will bring forward their spending to protect
themselves against future price rises which increases immediate consumption boosting AD
and creating additional demand pull inflationary pressures.
● Menu and shoe-leather costs: Menu costs are the costs of reprinting menus, catalogues and
labels as a result of high inflation - physical costs of printing which means firms may have to
further increase prices. Shoe leather costs are when high inflation discourages people from
holding money because nominal interest rates are higher so firms and HH save more -
people try to keep money in interest bearing accounts which requires frequent trips to the
bank which are known as shoe-leather costs. The reluctance to use money for transactions
may inhibit the effectiveness of markets -could lead to a barter economy e.g. in early 1980s
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