Table 16.1 Calculation of the retail price index
The rate of inflation is the percentage change in the RPI over the last twelve months and is calculated using the equation:
Rate of inflation = (Current RPI - Last RPI)/Last RPI x 100
At the beginning of year two the rate of inflation is:
(121 - 100)/100 x 100 = 21 per cent
See the of Biz/ed for a worksheet on calculating and interpreting index numbers.
Problems in Using the Retail Price Index
- Which items should be included in or excluded from the basket of goods?
- Different families have different tastes hence different weightings. How is an average family found?
- Not all regions in the country experience identical price changes.
- For a while new products ( eg mobile phones) may not be included in the index.
Effects of Inflation
Advantages of Inflation
Not everyone suffers from inflation. Some parts of society actually benefit:
- The government finds that people earn more and so pay more income tax.
- Firms are able to increase prices and profits before they pay out higher wages.
- Debtors (borrowers) gain because they have use of money now, when its purchasing power is greater.
Disadvantages of Inflation
- People on fixed incomes are unable to buy so many goods.
- Creditors (savers) lose because the loan will have reduced purchasing power when it is repaid.
- UK goods may become more expensive than foreign-made products so the balance of payments suffers.
- Industrial disputes may occur if workers are unable to secure wage increases to restore their standard of living.
Causes of Inflation
Cost-push Inflation occurs when a firm passes on an increase in production costs to the consumer. The inflationary effect of increased costs can be the result of:
- Increased wages, leading to
- a wage-price spiral, which occurs when price increases spark off a series of wage demands which lead to further price increases and so on;
- a wage-wage spiral, which occurs when one group of workers receive a wage increase which sparks off a series of wage demands from other workers.
- Increased import prices which can be the result of:
- a rise in world prices for imported raw materials;
- a depreciation of sterling
- Increased indirect taxation
Demand-pull inflation occurs when there is 'too much money chasing too few goods' because the demand for current output exceeds supply.
The figure below shows increased demand and increased prices as consumers compete to buy up goods still available.
A major source of inflationary pressure is the government which can print money to buy goods. The monetarist view of inflation can be stated in the equation:
MV = PT
where M = the money supply,
V = the number of times each pound changes hands (the velocity of circulation),
P - the average price of goods, and
T = the number of goods bought (transactions).
Monetarists believe that the values of V and T are fixed so that any increase in M, the money supply, must raise P, the level of prices, ie be inflationary.
Remedies of Inflation
- Introduce a prices and incomes policy to free price and wage increases.
- Encourage an appreciation of sterling.
- Reduce indirect taxation.
- Reduce government spending.
- Increase income tax to reduce consumer spending.
- Reduce peoples's ability to borrow money by increasing interest rates and tightening credit regulations.
- Control the supply of money.