Inflation: Sustained increase in general price levels.

Deflation: Sustained decrease in general price levels.

Consequences of Inflation

• Loss of purchasing power: If income is constant (no inflation linked incomes, weak trade unions)> fall in real income> purchasing power> standard of living falls. But some jobs offer security of inflation-linked incomes. However even then if rate of inflation is higher than expected> fall in real income
• Effect on saving: If inflation rate is very high, the real rate of interest will be negative> discouraging saving
• Effect on interest rates: Higher inflation leads to commercial banks raising their nominal interest rates to keep the real rate positive
• International competitiveness: If country has higher inflation than trading partners> export becomes less competitive>worsen trade balance.
• Uncertainty: Inability to predict forecast future prices discourages investment and consumer spending> fall in AD

Measuring inflation

• Most common statistic is CPI( consumer price index): Measure of cost of living of average household by tracking the prices of fixed basket of goods and services commonly bought by households. Change in CPI from one year to another can be used to calculate the inflation rate. Core rate of inflation excludes volatile items such as food and energy from CPI
• Since some expenditures are far more important than others weights are assigned to reflect the importance in the average consumer’s income

LIMITATIONS

• Different groups of people will have different rates of inflation since their purchasing habits and basket of goods may differ. The national average may not be applicable to them. Variations in regional rate of inflation within a country.
• Errors in collection of data affecting accuracy> impossible to measure prices in all outlets> sampling happens> this layers of sampling reduces accuracy
• Over time consumption habits change and statisticians have to account for those changes and update the basket. But this takes time. Plus changes in composition limits the ability to make comparisons form one year to another.
• Different countries have different ways and compositions of baskets and weights> difficult to make comparisons between countries
• Prices for some products are very volatile for eg energy and food > unusual movements in inflation> misleading
• Changes in product quality: Overstate the impact on Standard of living since it considers onlu the cost not quality changes.