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Inflation Worksheet - Are price increases inevitable?

This worksheet deals with the relationship between inflation and other economic variables. It also considers the causes of inflation from both demand and cost pressures. It then suggests some experiments on the Virtual Economy to see how inflation reacts to different policy changes.

Step 1 - The cycle of inflation

You may find the inflation explanation section helpful in finding out answers to the questions below.

How do we define inflation?

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What is the main measure of inflation in the UK?

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What other measures of price changes are there?

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The economy tends to follow a cyclical pattern of growth with boom periods and periods of lower growth or recession. This is known as the trade cycle. In the table below, fill in what you would expect to be happening to the economic variables given in a time of boom and recession:

Economic growth	Unemployment (High or low?)	Inflation (High or low?)	PSNCR (High or low?)
Boom / High growth
Recession / negative growth

Step 2 - What is inflating prices?

Use the inflation theory section of the Virtual Economy to find out answers to the questions below about the causes of inflation.

What are the main three causes of inflation?

1.

What different sources of cost-push inflation are there?

1.

What stage of the economic cycle is cost-push inflation most likely to occur at? Why?

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The Virtual Economy model is based on the Treasury's forecasts for the next decade. Go to the model and look at the forecasts for inflation over the next ten years.

When is demand-pull inflation most likely to occur in the next ten years? Why? (Justify your answer with reference to the data)

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Step 3 - Demanding inflation?

On the diagram below illustrate the inflationary effect of an increase in aggregate demand.

To see this effect in practice, we will try using some reflationary policies on the model, and see the effect they have on inflation.

Go to the model and try the following:

• Cutting income tax (perhaps 1% off lower rate, 2% off the basic rate and 3% off the higher rate?)
• Increasing government expenditure (perhaps by 10%)
• Cutting interest rates (perhaps by 2%)

Note the effects of these policies in the table below:

Year	2000		2001		2003		2005		2008
	Before policy change	After policy change	Before policy change	After policy change	Before policy change	After policy change	Before policy change	After policy change	Before policy change	After policy change
Growth (GDP %)
Inflation (%)

How much evidence is there of demand-pull inflation from these figures? (Refer in detail to the figures in your answer)

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Now try a series of deflationary policies to see if they have the opposite effect. Try the following:

• Increase income tax (perhaps 1% - lower rate, 2% - basic rate and 5% - top rate?)
• Reduce government expenditure (perhaps by 10%)
• Increase interest rates (perhaps by 2%?)

Note the effects of these policies in the table below:

Year	2000		2001		2003		2005		2008
	Before policy change	After policy change	Before policy change	After policy change	Before policy change	After policy change	Before policy change	After policy change	Before policy change	After policy change
Growth (GDP %)
Inflation (%)

How much evidence is there of reduced demand-pull inflation from these figures? (Refer in detail to the figures in your answer)

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What problems are there likely to be from trying to use fiscal policy as the main tool of economic management to control the level of inflation?

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What type of policy does the government tend to use mainly for controlling inflation?

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