What is inflation and how is it measured? (Including evaluation)

InflationDefinition: "Inflation is a sustained increase in the cost of living or the general price level leading to a fall in the purchasing power of money."Key Facts:1. The Government sets an inflation target is 2%2. The Bank of England (BofE) sets monetary policy interest rates to try and control inflation3. Do NOT say in your exam that inflation falls - make sure you say depreciation4. Inflation is meausred in the UK by the Consumer Price Index (CPI)How is CPI measured?A base year is selected and a family expenditure survey is carried out - the survey covers over 40,000 householdsA representative basket of goods and services used and weights are attached to each item - based on these items importance in people's expenditure as measured the family spending surveyEach month government officials collect 120,000 separate price quotations in 141 locations of around 600 productsExamples:Items brought into the CPI in 2013: White Rum, Hot Chocolate, Disposable Contact Lenses, E-readers and Continental FoodItems taken out of the CPI in 2013: Pairs of soft rounded contact lenses, Champagne, Gas BBQ's and Round lettucesLimitations of CPIBasic understanding that you can expand on in the exam: Few households are average – the published figure for inflation is rarely the actual rate of inflation experienced by different people.In more detail...1. The CPI is not fully representative - it will be inaccurate for the non-typical household2. Spending Patterns3. Changing quality of goods and services4. New ProductsMain Causes of InflationDemand Pull Inflation- Caused by excess aggregate demand- Often linked to a money and credit boom- Economy close to full capacity (inelastic AS)- Positive output gap (AD > potential GDP)Cost Push Inflation- Rising wage costs in labour market- Increasing raw material and component costs from domestic and overseas suppliers- Rising import prices due to a falling exchange rate – this increases import costsAdministered Prices- Changes in regulated prices e.g. water bills- Changes in indirect taxes and subsidies- Changes in environmental taxesInternal Causes of Inflation - A large surge in property prices- Higher wages/ labour costs- Boom in credit / money supply- Rise in business taxes e.g. VATExternal Causes of Inflation - Increase in world oil/ gas prices- Inflation in global commodity prices- High inflation in other countries- Depreciation of the Exchange RateWhy is Inflation an Economic Problem- Inequality- Falling real incomes- Negative real interest rates- Cost of borrowing - Risks of wage inflation- Business competitiveness- Business uncertainty