So we all knew what inflation was in AS but now we have to know it in more depth.

 I think one of the most important things to cover is how it’s measured.  If inflation is part of the exam paper then it is very likely that a fifteen marker will be dedicated to defining how inflation is measured.

 

EXAM TIP: When defining it, remember: DO NOT write that it is an increase in price. To get the full marks you need to right that is a SUSTAINED increase in GENERAL PRICE LEVEL.  

 

Why? Think about it, inflation change is calculated in percentage so if you say there’s an increase in price, it is way too specific. In theory, you’re correct. Price does rise, but you must say it is the rise in PRICE LEVEL. Because if prices were going to rise according to inflation, you wouldn’t say “raise the price of the product by £3”.  You would say raise it by X%.

Does it make sense to raise the price of bread by £3 as well a Ferrari? Nope.  That’s why, never say a raise in price but a raise in PRICE LEVEL.

 

MEASURING INFLATION:

 

Consumer Price Index (CPI): This is the main form of measuring inflation in the UK. This CPI is measured every 12 months and is a weighted price index.  The government’s target is 2% (+/- 1%).

A typical basket of goods and services is collected.  This is changed every year from the information that is collected from the Family Expenditure Survey.

CPI basically calculates the spending of CONSUMERS in the country.  So it will look at those goods and services that are paid for regularly by households.  For example: Food, Clothing, Transport and Housing.

A ‘weighting’ is basically how much people use that good or service.  So the higher the income spent on that good/service the high its weight.  For Example: If 25% of a household’s income is spent on Food, then its weight will be 25.  This is then done overall after everyone’s information has been submitted and an overall weight will be given to the good/service.

 

EXAM TIP: In a exam, it may be that the 5 mark question asks you to calculate the price index based on a given case study.  The way to do this would be à  MULTIPLY all the Price Indices by their respective weights. These values will be given to you in the table.  You would then ADD together all the values given to you.  Then you would just DIVIDE the sum by the total of the weights (This is usually provided to you and is 100).  The value you end up with will be the Price index for that year.

Don’t forget to round this to the decimal place that they ask.

 

It is typical that if an inflation paper is given to you that there is a 15 marker on why CPI is not a useful indicator.  Below are the reasons.

 

LIMITATIONS OF USING THE CPI TO MEASURE INFLATION:

• Different groups of people are experience different rates of inflation.  The CPI measures the inflation rate for ‘typical households’ this means that it does not represent the households that consume differently.  For example: a weighting towards tobacco will be irrelevant to non-smokers.

 

• The CPI doesn’t include house prices.  Even though it does include Mortgage Payments it is because they are paid regularly so therefore take a certain amount of your income everyone month for example.  However, people who do not pay a mortgage are not included as they have paid of their mortgage.  For Example: Older buyers would have paid off their mortgage whereas younger buys would have not, unless they can afford to.

 

• CPI may over-estimate inflation. Why? Because the increase in price level may not be due to the rise in demand or the costs of production.  It may be simply due to an improvement in the quality of a good or service.  This justifies an increase in price and is NOT counted as inflation, yet CPI may not take this into consideration.

 

• OVERALL: The consumer price index may be inaccurate due to the fact that is does not full represent the prices that all households face.  Therefore, it is NOT a useful indicator.