What are the effects of inflation on an economy?

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Clint Sinclair                20/04/2004

What are the effects of inflation on an economy?

Inflation can be defined as a sustained rise in general price levels. This is a very general definition as there are so many factors that have to be taken into account when considering the General price level of an entire economy.

In the UK, inflation figures published and announced once a month give certain percentage rates of inflation. These are annual percentage rates indicating the change in inflation between the current year and the previous of the same month. The Retail Price Index (RPI) is the most famous, but the government prefers to quote the RPIX. Although other measures are used for calculating inflation, these are the most widely used methods in the UK.

The RPI is a set of numbers that show the monthly change in the average of a sample of goods and services. There is an annual family expenditure survey that is used to decide which services are to be used in the sample and which are most important of those. In this sample typical household expenditure such as, food and housing costs would be considered whereas tobacco would not. Therefore, The inflation figures that form the RPI is the annual percentage change in this index from the most recent month compared with the same month in the previous year. This is known as the headline rate of inflation.

 Alternatively the government will regularly publish the underlying rate of inflation, otherwise known as the RPIX.  The ‘X’ doesn’t actually mean anything; it’s just a symbol that allows us to differentiate between the RPI and the RPIX. This comprises of exactly the same, as the headline rate of inflation except it does not include mortgage interest repayments. though this is a very important part of household expenditures, interest rates and inflation are directly linked. When it is felt that future inflation will rise above the government target, interest rates are raise to reduce aggregate demand and dampen inflationary pressures. The problem is that raising interest rates directly affects the RPI (through higher mortgage interest), so the instrument that is being used to control inflation affects the inflation rate itself. Thus the government prefer to target inflation based on the RPIX, because the mortgage interest payments are excluded.

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The final presentation of the retail price index is the RPIY. This takes the RPIX one further. This is the same as the RPIX, but excludes indirect taxes as well. This is also a government-controlled factor, which means that it can be considered to not represent true rates of inflation; especially the government can increase taxations for environmental reasons. Arguably one could say that removing all these factors in calculating inflation would give an inaccurate indication of consumer spending and the price of their spending.

Taking a carefully selected sample of outlets and finding an average price for the each ...

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As this essay goes completely off the question, it is difficult to comment on the structure and the way it responds to the question. However, I did like the progression from knowledge to analysis as shown here. Sometimes words are capitalised when they shouldn't be, for example "the General price level". This isn't a drastic error, but it does show a lack of fluency and sophistication. Technical terms are used throughout, and it is easy to see these with the bolding in the first section. Spelling, punctuation and grammar are fine.

The analysis here is sound. I really liked the introduction to inflation, albeit slightly lengthy, as it shows a really strong knowledge of why it is relevant. Giving a definition, showing how it is measured and what different types exist is always a good way to build the foundations to an essay on inflation. I was a bit worried to see "With continuous changes in the interest rates, time is initially lost, as consumers will shop around for the cheapest possible price of products." as this is completely irrelevant to effects of inflation. The discussion of "investors will not be willing to risk investing" is one that examiners like, but unfortunately this essay hasn't elaborated upon this point. I would be analysing how this will affect aggregate demand, with a diagram, and showing how it will impact the exchange rate and international competitiveness. It is this further analysis on the points given which will gain the top marks. Demand-pull and cost-push inflation are covered briefly, and I would've liked to have seen a diagram showing this.

This essay responds poorly to the question, but if this was a general overview of inflation it would have been good. Inflation is defined well, yet there seems to be more focus on the causes of inflation, and policies to reduce it, rather than the effects. I cannot stress how important it is to answer the question, as it is a common mistake for students to just put down everything they know. Even if some of your work is relevant, you'll be penalised for going off focus! It is evident here that the costs have not been elaborated upon, which is a shame, as there's plenty of analysis that could've been done!