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Economics- Theme 2 > 11- Inflation > Flashcards

11- Inflation Flashcards

1
Q

Inflation definition

A

A sustained general rise in prices across an economy.

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2
Q

Deflation definition

A

A sustained general fall in prices across the economy

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3
Q

Disinflation definition

A

A fall in the rate of inflation

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4
Q

Hyperinflation definition

A

A very high general rise in prices across an economy. Around 50% or more per annum.

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5
Q

Reflation definition

A

The rise in GDP which occurs following a recession

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6
Q

Stagflation definition

A

A period when inflation is rising or is very high at the time of the economy.

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7
Q

Measures of inflation in the UK

A
  • CPI (consumer price index)

- RPI (retail prices index)

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8
Q

How is the CPI measured?

A

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.

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9
Q

UK inflation target

A

2% +- 1% by CPI

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10
Q

What is used to influence inflation?

A

Interest rates set by the monetary policy committee at the Bank of England (BoE).

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11
Q

Consequences of high inflation?

A
  • 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.
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12
Q

Winners of inflation

A
  • Workers with strong wage bargaining power
  • Debtors if real interest rates are negative
  • Producers if price rise faster than costs
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13
Q

Losers of inflation

A
  • Retired or fixed incomes
  • Lenders if real interest rates are negative
  • Savers if real returns are negative
  • Workers in low paid jobs
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14
Q

Consequences of deflation

A
  • 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
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15
Q

Causes of inflation

A
  • Demand pull
  • Cost push
  • Growth of money supply
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16
Q

Causes of demand pull inflation?

A

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

17
Q

Demand pull inflation shown on diagram

A

AD shifts right

18
Q

When does demand pull inflation occur?

A

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.

19
Q

When does cost push inflation occur?

A

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.

20
Q

Causes of cosh push inflation?

A

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

21
Q

Cost push inflation on AS/AD diagram

A

SRAS shifts left

22
Q

Deflation effect on real value of debt

A

It increases real value of debt - it makes it more difficult for debtors to pay back loans. They have to prioritise debts, reducing consumption.

23
Q

What is the money supply?

A

Is a measure of the amount or stock of money in the economy.

24
Q

Money supply definitions

A
  • 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
25
Q

Effect of economic growth on the money supply?

A

The more the economy grows throughout the years a greater supply of money due to increased transactions.

26
Q

How can the government increase the money supply?

A
  • 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

27
Q

Equation for money supply

A

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.

28
Q

How the growth of the money supply causes inflation?

A

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.

29
Q

Strength of link between growth of the money supply and inflation?

A
  • 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.
30
Q

Quantitive easing

A

This involves the Central Bank increasing the money supply and using these electronically created funds to buy government bonds or other securities.

31
Q

Aims of quantitive easing

A
  • 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
32
Q

How quantitive easing works

A
  • 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.
33
Q

What would happen if there is more money chasing the same amount of goods? Irving Fischer equation for this?

A

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

34
Q

Other factors causing inflation?

A
  • 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.

Economics- Theme 2 (19 decks)

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