18. Low and stable rate of inflation

Question 1

WHat is price stability

Answer 1

low and stable inflation

Question 2

Define inflation

Answer 2

INFLATION: a persistent increase in teh avergae price level in agiven economy at a certain price level

Question 3

Disadvatages of high inflation

Answer 3

• loss of purchasing power: price level rises but wages stay the same
• effect on savings: value decreases - inflation discourages savings - better buy real estate/art
• effect on interest rates: increase in borrowing price
• effect on international competitiveness: exports less, imports more competitve
• uncertainty: hence discouraged from investing
• labour unrest: disputes if workers dont feel their wages keep up with inflation

Question 4

Define deflation

Answer 4

DEFLATION: a persistent fall in the average price level ina an economy

Question 5

Explain good-deflation

Answer 5

from improvements in the supply side/increased productivity (increase in LRAS)

GOOD: increase in output, decrease in unemployment

Question 6

Explain bad deflation

Answer 6

From demand side (fall in AD - fall in output - lower employment - lower productivity)

BAD: decrease in output, increase in unemployment

Question 7

Define disinflation

Answer 7

DISINFLATION: inflation of a falling rate

Question 8

Disadvantages of deflation

Answer 8

Costs of deflation > costs of inflation

• unemployment: low AD - lay off workers -> deflationary spiral: prices fall - consumers put off purchases of durable goods - deferred consumption - fall in AD
• effect on investment: businesses make less profit - reduced investment - harm economic growth
• costs to debtors: a loan rises in value as now the money is worth less than when it was taken - difficult to pay back

Question 9

How is inflation measured?

Answer 9

Consumer price index (CPI): not all prices change the same - consumer good and service basket - how the price of all basket changes measured each month

Each country creates own representative basket - typical goods and services households buy (surveys) - each category is given weight as some products are more important

Also producer price index (PPI) - tracks prices of goods as they leave factories - before distributors/retailers/wholesalers

Question 10

Issues in inflation measuring

Answer 10

• typical basket applies not to all people - purchasing habits vary (regionally, financially)
• errors in data collection
• changes in consumer habits
• problematic comparison as countries meaure inflation differently

Question 11

Types of causes of inflation

Answer 11

• demand-pull
• cost-push
• demand and cost push together
• excess monetary growth

Question 12

Explain demand-pull inflation

Answer 12

Due to increase in D (change in components) - pulls up price level

Question 13

Explain cost-push inflation

Answer 13

Due to increase in costs of production - fall in SRAS

• wage -push inflation: increase cots of labour
• cost-push pressures: costs of production - commodities
• import-push pressures: increase in costs of imported capital/commodities

Question 14

Explain demand pulld and cost push inflation together

Answer 14

Inflationary spiral: increase in AD - increase in price level - higher costs - decrease in SRAS - increase in price level - increase in wages - consumers seem that they have more money - higher AD - higher price level

Question 15

Explain inflation due to excess monetary growth

Answer 15

Monetarists argue that excessive increase in supply of money is the cause of inflation (increases AD)

Question 16

Ways to reduce demand pull inflation

Answer 16

Policies to reduce inflation depend on the type

Demand-pull: reduce AD - deflationary fiscal policy (increase taxes, lower gov spending) / deflationary monetary policy (raise interest rates, reduce money supply)

However, contractionary policies are problematic: fiscal would not be favoured by voters, time lag, monetary - increases debt

So monetary policy carried out by central banks - main goal: maintaining low and stable rate of inflation - can make politically unpopular decisions => monetary policy more effective in tackling inflation

Question 17

Ways to reduce cost push inflation

Answer 17

Policies to reduce inflation depend on the type

Cost push: deflationary demand side policies may bring down price level but will also decrease output - supply side better

However, in reality hard to destinguish between demand pull and cost push - use both demand and supply side in mix

Gov unlikely to make unpopular decision - central bank’s responsibility

For monetarists: money supply should increase the same proprotion as output