11.3 Inflation and deflation

Question 1

What are the two types of Inflation

Answer 1

Demand pull inflation and cost push inflation

Question 2

what is the definition of inflation?

Answer 2

Inflation is a sustained rise in an economy’s general price level

Question 3

How does Demand pull inflation occur?

Answer 3

Demand pull inflation occurs when aggregate demand shifts to the right

Question 4

Explain the chain of reasoning on why we see demand pull inflation?

Answer 4

When aggregate demand shifts to the right their is greater pressure on the existing factors of production to produce more output as they are becoming scarcer. therefore when more pressure is put on a scare resource prices rise. e.g. wages will increase, price increase so costs of production increases and firms pass on costs to consumers so prices rise

Question 5

What factors can lead to demand pull inflation?

Answer 5

reduction on interest rates

lower income/cooperation tax

boost in consumer/ business confidence

increase in government spending

weaker exchange rate

Question 6

How does cost push inflation occur?

Answer 6

Cost push inflation occurs when SRAS shifts to the left.

Question 7

Explain the chain of reasoning on why we see cost push inflation?

Answer 7

SRAS shifts to the left when their is an increase in cost of production for the majority of firms in the economy. firms pass on higher costs to consumers via higher prices of goods and services

Question 8

what factors can lead to cost push inflation?

Answer 8

increase in the price of raw materials

increase in wages

increase in business tax

increase in price of imported raw materials due to weak exchange rate

Question 9

What is the definition of deflation?

Answer 9

The persistent fall in prices in an economy in a year.

Question 10

what are the two types of deflation and which one is good or bad?

Answer 10

Demand side (bad) supply side(good)

Question 11

when does demand side deflation occur?

Answer 11

when aggregate demand shifts to the left

Question 12

when does supply side deflation occur?

Answer 12

when short run aggregate supply shifts to the right

Question 13

Why is demand side deflation bad?

Answer 13

demand side deflation is bad as it comes with lower growth

deflation is assumed to be long term and anticipated e.g. recession last for a time.

Question 14

why is supply side deflation good?

Answer 14

supply side deflation is good as it comes with higher growth

more likely be short term and unanticipated e.g. material prices may be low today causes deflation but is very volatile

Question 15

Why is anticipated deflation dangerous?

Answer 15

Delayed spending (reduces AD so lower growth high unemployment)

positive real interest rates (incentivises saving)

increase in value of debt (profits and incomes fall harder to service debt as it stays the same)

Question 16

Why is short term inflation good?

Answer 16

lower price for consumers improves living standards

falling prices means businesses can buy inputs (e.g. capital/ stock reducing costs of production)

Question 17

what are the costs of Inflation?

Answer 17

loss of purchasing power (effects living standards)

erodes savings as interest rates aren’t following effects lots of the economy e.g. pensioners who live off savings

lower export competitiveness (worsening current account)

risk of anticipated inflation e.g. workers asking for higher wages further increasing inflation and rational consumers buy more

fiscal drag (inflation rises and workers pay rises the same but could push workers into higher band of progressive income taxes system)

inflationary noise (volatile inflation could lose value of price signalling function) so consumer put of consumption + firms put off investment

shoe leather costs e.g. consumers search for best prices = opportunity costs

menu costs firms have to adjust price lists often

Question 18

what are the benefits of inflation?

Answer 18

workers can bargain for higher prices (good for moral)

consumption is more natural

firms encouraged to increase output profit (incentive)

unemployment low in recession

easer to service debt

improvement in government finances e.g. VAT revenue increase as price of products rises

Question 19

what is the macro objective for inflation

Answer 19

low and stable inflation