11.3 Inflation And Deflation Flashcards
What is inflation?
A persistent or continuous rise in price level or as the continuing fall in price level the value of money to rise
What was the rate of inflation in 1980?
20%
What was the inflation rate in 1990?
10%
What does deflationary policy involve?
Fiscal or monetary policy to reduce aggregate demand and levels of economic activity,output and unemployment
What are the two types of inflation
Cost push
Demand pull
What is demand-pull inflation?
(Demand inflation)
A rising price level caused by an increase in AD shown by a shift of AD to the right
What is cost push inflation
( cost inflation)
A rising price level caused by an increase in the costs of production, shown by a shift in the SRAS curve to the left
What is demand pull inflation caused by
Increase in AD
What does to the left of the LRAS curve mean?
Producing below the normal capacity of output
What happens when the economy is initially producing the on the economies SRAS curve but below the normal capacity level of output?
The price level has to rise to persuade firms to produce more output to meet the extra demand
What can lead to demand pull inflation?
An increase in any of the components of AD
-consumption
-investment
-government spending
-export deficit
Diagram for demand-pull inflation
Describe how this diagram shows demand-pull inflation
-equilibrium national income is at point X
-the initial point of AD is AD1
-shift to AD2 causes price level to rise to p2
-real national income Increases to normal carport level of Yn
What does this diagram imply
-economy producing below normal capacity level of output and then moving to a normal
- capita of output
-following increase in AD equilibrium point becomes Z with economy on LRAS curve
-any shift past z results in demand pull inflation
What it be inflationary to increase AD from point V
Would increase output and employment and a little effect on inflation
What is the cause of cost push inflation
Structural and institutional conditions on the supply side of the economy particularly in the labour market and the wage-bargaining process
(Wage-cost inflation)
-rising prices of energy/ commodities can also cause cost push inflation (import-cost inflation)
What do cost push theories generally argue?
The growth of monopoly power in the economy’s labour market and in its market for goods and services is responsible for inflation
Diagram for cost push inflation
Describe how the diagram shows cost push inflation
X=equilibrium national Income
Real output=y1
Price level=p1
Money costs of production that firms incur rise because money wages or the price of imported raw materials rise, increases production costs and SRAS shifts left
Shift left cusses price level to rise to p2, the amount of output firms are willing to produce decreases to y2 from y1, new point of z
What is easier to fix cost push or demand pill
Demand pull
What can be done to fix cost push inflation
Reduce inflation target
Reduce vat and subsides to firms
Who are monetarists?
Economists who argue that a prior increases in the money supply is the caused of inflation
What is monetarism?
Narrow monetarism centres on increases in the money supply as the prime cause of inflation. Broader monetarism focuses on the virtues of free markets in resource allocation
Free market economists are known as?
Monetarists
Monetarists subscribe to the theory of ….
Demand-pull inflation but go a stage further by arguing that excess AD for output is caused by a prior increase in money supply
What is monetarist economic theory known as?
Monetarism
What theory lies at the heart of the monetarists theory of inflation?
The quantitive theory of money
What is the quantitative theory of money?
Oldest theory of inflation, states inflation is caused by a persistent increase in the supply of money
According to the quantity theory of money, what happens when expansion of money supply is greater than the increase in real national income?
Households and firms have excess money which when spent drive up the price level (too much money chasing too few goods)
What is the equation of exchange
Money supply(stock of money) x the velocity of three circulation of money= price level x quantity of output
MV=PQ
What is the velocity of circulation?
Speed of which money circulated around the economy when people use money to buy goods
What does it mean when monetarists argue that v is constant or stable?
When M increases, it is spent on services, if Q is unable to increase the price level (P) is pulled up by excess demand
What do Keynesian economists believe when M increases?
It may be partially absorbed by a showdown in , which means the much of the extra money is not spent on customer goods and services
The PQ on the right hand side of the equation can increase either because real output increases or the price level increases
What is the equation of exchange written as and what does T stand for?
MV=PT
T stands for total transactions taking place in the economy
-comes from American economist Irving Fisher
Why is PQ a better measure of PT for expenditure on national output?
Because total transactions include second-hand transactions as well as the exchange of new goods and services
What do Keynesian economists think about the quantity theory of money as an explanation of inflation
They reject it
What are the three main ways Keynesian economics have attacked the quantity theory
-the velocity of circulation is not constant
-under-full employment equilibrium
-reverse causation
Why do Keynesian Economists attack the quality theory of money with under-full employment equilibrium?
-if there is spare capacity and unemployment in the economy, an increase in the money supply may increase real outcome and output rather than the price level P
-market forces are too weak and take too long to return the economy to its normal capacity output, the economy can get stuck in an under-full employment equilibrium
Why do Keynesian Economists attack the quality theory of money with the velocity of circulation is not constant?
-question wether the velocity of the circulation of money is constant(v represents how often money is spent)
Monetarists believe that money earns little or no interest should spent it straight away
Keynesian argue under certain circumstances (when share and bond prices are expected to fall) it it sensible to hold idle money balance
What is inflation?
Sustained rise in an economy’s general price level
What is hyperinflation?
Phase of extremely rapid inflation nearly always with he result of mass Monet printing by the government with money as an asset ending up as worthless
Why do Keynesian Economists attack the quality theory of money with reverse causation?
If a gov tightly restricts the growth of money to try and stem inflation, the main effect might be that the current level of transactions cannot be financed, so real activity will fall
Deflation
A sustained period when the vernal price level for goods and services is falling
Can people’s expectations of future inflation affect current inflation rates?
Yeah
Who was the leading Monetarist who found that people’s expectations of future inflation affect current inflation rates
Milton Friedman
What is disinflation
Fall in rate of inflation but not sufficient to bring about price inflation
How can future inflation expectations affect current inflation
Because people will react in an inflationary way now
Who benefits from inflation
Home owners
Government (debt decreases)
What are the two theories of future expectations of inflation
Adaptive expectations
Theory of rational expenses
What is creeping inflation
When inflation is low year on year and easy to predict
Why is a low but stable inflation rate important for labour markets to run efficiently?
When prices are completely stable, to cut real wage rates nominal wage rates have to fall
With 0 inflation the changes required in relative wage rates needed to make labour markets function efficiently fails to take place
What does inflation lead to(6)
-risk of wage inflation
-falling real incomes
-inequality (affects poorer people more)
-higher cost of borrowing
-business uncertainly
-less business competitiveness
What are the effects of inflation?
-disproportionate effects
-distortion of normal economic behaviour
-breakdown of functions of money
-reduced international uncompetitiveness
How does inflation have disproportionate effects?
Weaker social groups on fixed incomes lose out
How does inflation distort the normal economic behaviour?
Distorts consumer behaviour causes households to bring forward purchases if they expect the rate of infection to accelerate
How does inflation cause the breakdown in the functions of money?
Money becomes less useful and efficient as a medium of exchange and store of value
How does inflation lead to reduced international uncompetitiveness
When inflation is higher than in competitive countries exports increase in price ,putting pressure on fixed exchange rate
Lower growth and rising unemployment are likely to result
Who benefits from inflation?
Workers with strong wage bargaining power
Debtors if real interest rates are negative
Producers if prices rise faster than costs
What is the triple lock?
Rate at which the pensioners incomes go up each year
What is extended deflation an issue?
When people believe prices are going to fall they postpone big spending decisions
Diagram for ‘good’ deflation
Diagram for ‘bad’ deflation
Describe this diagram
(Good deflation)
Results in improvement in economies supply side reduces business cost and costs In production so price level falls but employment and output rises
Describe this diagram
Bad inflation
Reduced AD has negative multiplier effects and possibly a credit crunch
How do changes In other countries affect UK inflation?
When times are good in world economy with rising demand for commodities UK imports inflation
When times are bad the pressure on UK inflation is reduced
What does a fall in the pounds exchange rate to other currencies lead to
Cost-push inflation
Which two countries affect the the UK price level the most?
USA
China
What is the final thing that can affect UK inflation rates
Supply and demand unforeseen shocks
What do the economic effects on inflation depend on?
-if high inflation is temporary or persistent
-wage bargaining power of workers in different industries
-whether nominal interest rates on savings and loans keep pace with inflation
-does uncertainty lead to a fall in domestic and foreign inward investment
-extent to which a central bank is prepared to tolerate inflation without raising interest rates
