11- Inflation Flashcards
Inflation definition
A sustained general rise in prices across an economy.
Deflation definition
A sustained general fall in prices across the economy
Disinflation definition
A fall in the rate of inflation
Hyperinflation definition
A very high general rise in prices across an economy. Around 50% or more per annum.
Reflation definition
The rise in GDP which occurs following a recession
Stagflation definition
A period when inflation is rising or is very high at the time of the economy.
Measures of inflation in the UK
- CPI (consumer price index)
- RPI (retail prices index)
How is the CPI measured?
A basket of goods and services from the results of living costs and food survey. Each year, a few thousand households are asked to record their expenditure for one month. Then a weighted price index is calculated.
UK inflation target
2% +- 1% by CPI
What is used to influence inflation?
Interest rates set by the monetary policy committee at the Bank of England (BoE).
Consequences of high inflation?
- Inequality: has a regressive effect on lower income families in developed + developing countries- most of their wealth is held in cash.
- Falling real incomes: wage rises lag behind price increases each year
- Negative real interest rates: if interest on savings is less than inflation.
- Cost of borrowing: high inflation may also lead to higher interest rates for businesses and consumers with debts (higher mortgages).
- Risk of wage inflation: leads to rising labour costs + lower profits.
- Businesses competitiveness : a high relative rate of inflation can reduce competitiveness which will lower demand for country’s exports.
- Business uncertainty: and volatile inflation is not good for confidence for confidence partly because businesses cannot be sure of what their costs and prices are likely to be. This may lead to a fall in capital investment.
- Menu costs
- Shoe leather costs: with lots of price changes consumers will not be clear of reasonable prices- which leads to more shopping around.
Winners of inflation
- Workers with strong wage bargaining power
- Debtors if real interest rates are negative
- Producers if price rise faster than costs
Losers of inflation
- Retired or fixed incomes
- Lenders if real interest rates are negative
- Savers if real returns are negative
- Workers in low paid jobs
Consequences of deflation
- Holding back on spending: consumers may postpone demand if they expect prices to fall in the future.
- Debts increase: The real value of debts rise with deflation and higher real debts can be a bad drag on consumer confidence
- The real cost of borrowing increases: real interest rates will rise if nominal rates of interest do not fall in line with prices
- Lower profit margins: Lower prices can mean reduced revenue and profits for businesses- this can then lead to higher unemployment as firms seek to reduce costs by shedding labour.
- Confidence and saving: Falling asset prices such as price deflation in the housing market hits the personal sector wealth and confidence.
- Income redistribution: from debtors to creditors- but debtors may default on loans
- Can make exports more competitive in the long term but can lead to higher unemployment in the short term
Causes of inflation
- Demand pull
- Cost push
- Growth of money supply
Causes of demand pull inflation?
Reduced taxation:
- Increases disposable income
- Increase consumption
Lower interest rates:
- Makes borrowing more attractive and less saving
- Increases consumption
General rise in consumer spending:
- Potential higher incomes and confidence
- Increases consumption
Improved availability of credit:
- Banks/ building societies make credit more available
- Increases investment therefore AD
A weak exchange rate:
- Will boost export growth
- Increase AD
Fast growth in other countries:
- Increase in UK exports
- Pound will be weaker therefore AD increases
General rise in confidence/ expectations of future growth and certainty
Demand pull inflation shown on diagram
AD shifts right
When does demand pull inflation occur?
Demand pull inflation occurs when aggregate demand and output is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap.
When does cost push inflation occur?
When firms respond to rising costs of production by increasing prices. Firms will do this to protect profit margins. Costs will be passed to consumers.
Causes of cosh push inflation?
Wage increases:
- For firms, wages is often biggest cost
- If prices go up workers will demand higher wages to keep real value
- Wage spiral- they will keep demanding more wages are prices go up
Higher raw material costs:
- As primary raw materials become more scarce and in ever greater demand, prices for these will rise
Higher taxes:
- Imposed on firms by government e.g. corporation, national insurance, VAT
Higher import prices:
- A weaker exchange rate or rising prices abroad that imported components feed through to higher costs of production
Natural disasters:
- May temporarily or permanently reduce the supply of raw materials or disrupt supply chain, affecting costs
Cost push inflation on AS/AD diagram
SRAS shifts left
Deflation effect on real value of debt
It increases real value of debt - it makes it more difficult for debtors to pay back loans. They have to prioritise debts, reducing consumption.
What is the money supply?
Is a measure of the amount or stock of money in the economy.
Money supply definitions
- MO is known as narrow money and includes notes and coins in circulation and some liquid assets.
- Broad money e.g. M4 includes a wider definition of money including M0, bank account deposits and other liquid assets
Effect of economic growth on the money supply?
The more the economy grows throughout the years a greater supply of money due to increased transactions.
How can the government increase the money supply?
- Printing more notes through the bank of England
- Use quantitive easing to create money electrically
- Reduce deposit holdings of banks allowing them to lend more money (by law UK banks must hold a certain percentage of deposits to provide liquidity).
- The Bank of England can buy bonds off financial institutions creating liquidity. The financial institution will pay a fixed sum on an annual basis for this.
Bonds are tradeable and have a redemption for when it matures
Equation for money supply
MV = py
M= money supply V= velocity
p= prices y= national income
The equation must balance and M should only be increased if y is growing less than P.
How the growth of the money supply causes inflation?
If you assume that V is fixed then an increase in M that is bigger than T/y will lead to an increase in the price level.
Strength of link between growth of the money supply and inflation?
- Many feel that the link between the money supply and inflation is a weak relationship V may well be flexible and notified.
- Also when interest rates are low, increases in M are likely to have little effect on interest rates. This is known as the liquidity trap.
Quantitive easing
This involves the Central Bank increasing the money supply and using these electronically created funds to buy government bonds or other securities.
Aims of quantitive easing
- Increase economic activity – Q.E. aims to encourage bank lending, investment and therefore help improve the rate of economic growth.
- Higher inflation rate. Quantitative easing may also be used to avoid the prospect of deflation
- Lower interest rates on assets
How quantitive easing works
- The Central Bank creates money electronically. (This is a similar effect to printing money, except they are increasing bank reserves which don’t need to be printed in the form of cash)
- The Central Bank uses these extra reserves to buy various securities. These include government bond and corporate bonds.
What would happen if there is more money chasing the same amount of goods? Irving Fischer equation for this?
Prices are likely to rise.
PT = MV
P= Prices T= No. of transaction M= Money supply V= Velocity of money
Any increase in M would lead to inflation
Other factors causing inflation?
- Expectations- if people expect higher rates of inflation , then they will likely push for higher wages- this will impact business costs and lead to wage- price spiral.
- Currency depreciation will lead to higher import prices
- Administrative costs and indirect tax increase.
