2.4 Inflation Flashcards
What is the definition of inflation ?
inflation is defined as a sustained increase in the average price level of an economy over a given period of time
- inflation means that the purchasing power of money falls over time.
What is the definition of deflation ?
deflation is defined as a sustained decrease in the average price level of an economy over a given period of time
What is the inflation rate ?
inflation rate is the percentage change in the average price level over a given period of time
Inflation is indicated by +rate
Deflation is indicated by -rate
What is disinflation ?
disinflation means a fall in the rate of inflation, the price level is increasing but at a slower rate over time
What is hyper inflation ?
hyperinflation means a very high rate of inflation; prices are increasing so fast there is a severe loss of confidence in the value of money
Hyperinflation inflation: 50% a month, meaning 13,000% annually
How is inflation measured ?
- the CPIH is the consumer prices index including owner occupiers housing costs
- the CPIH and CPI are based on consumer prices and the price of a representative basket of goods/services for a typical UK households, these price indices are weighted to certain G/S
- prices of the goods and services are taken from the result of family expenditure survey
How to calculate the inflation rate ?
**inflation rate% = ((index value in a given year - index value in previous year)/ index value previous year) x 100 **
- usually calculated year on year
What are CPIH and OOH ?
- OOH costs are the costs of housing services associated with owning, maintaining and living in one’s home
- this is useful since these represent a large proportion of consumption expenditure
comparing measures of inflation
What are the problems in measuring inflation ?
- the basket may not be fully representative for any specific households, difficult to judge typical household
- changing technology can make it difficult to accurately calculate change in the price level
- time lags In inflation calculations
- difficult to account for increasing quality
- shrinkflation: changing the size of products rather than the price could cause issues.
- not comparable due to many different measures of inflation
What is demand-pull inflation ?
occurs when there an increase in aggregate demand pull up prices
What is cost-push inflation ?
where there is a decrease in SRAS push up prices
What are the possible consequences of inflation ? (Pt1)
1a) menu costs - costs associated with firms having to change prices of G+S
1b) administrative costs - costs of renegotiating contracts
1c) shoe leather costs - cost incurred in terms of time to ensure money doesn’t lose its value
2) reduction of the value of money - the purchasing power of money falls as the price increases. The same amount of money will buy progressively less over time
3) redistribution effects - if some workers do not receive wage increases that keep with inflation, and some do, real income will be redistributed.
4) fall in real income and standard of living - if nominal wages do not increase in line with inflation, real income falls, households will be able to buy less G+S, decreasing SoL
What are the possible consequences of inflation ? (Pt2)
5) redistribution from savers to borrowers - inflation leads to a fall in the real value of savings because nominal interest rates may not rise by the rate of inflation
debtors gain because the real value of debt falls e.g inflation means that the real value of the mortgage falls, however interest rates may be linked to inflation
6) inflationary noise - rising prices can lead to market signals being distorted, it is difficult for consumers to recognise which products are worth buying, further reducing confidence
7) fiscal drag - if tax brackets are not changed in line with price rises, there can be redistribution from taxpayers to the government, increasing government revenue.
What are the possible causes of inflation ? (Pt3)
8) inflation causing to further inflation - inflation can lead to expectations of increase in prices, meaning households bring forward purchases increasing AD in the short run, further increasing inflation
9) uncertainty, inflation can lead to uncertainty, firms will be less certain of future costs and prices they will receive for their products. Loss of both business and consumer confidence, lower spending and investment
10) loss of international price-competitiveness - if domestic inflation is higher than in other countries, this may lead to domestically produced goods and services becoming less price-competitive in international markets.
Possible benefits of low and stable inflation
1) greater certainty for firms and consumers, increasing business confidence and consumer confidence
Low and stable rates of inflation may encourage firms to invest more because they fell prices of products will rise steadily
2) lower expectation of future inflation, central bank may help to instil expectations of low and stable inflation, providing greater certainty for firms and households
3) more flexibility for producers - to decrease real wages by not increasing nominal pay at the same rate as inflation.
Evaluating the consequences of inflation ?
Depends on:
1) the rate of inflation - a higher rate is likely to be more harmful
2) inflation rate relative to other countries
3) the duration of inflation
4) cause of inflation - cost-push likely to be more harmful
5) distribution of income
What is benign deflation ?
benign deflation occurs when the price level is falling due to falling costs of production (SRAS), shown by a shift to the right of SRAS curve
What is malign deflation ?
Malign deflation occurs when the price is forced down by lower total spending on goods and services, lower AD, shifting to the right. Causes by anything that decreases AD
What are the costs of deflation ?
1) increasing value of money (less incentive to spend), purchasing power increases as prices fall
2) reduced consumer spending consumers expect prices to fall further, delaying their purchases, particularly expensive G/S
3) reduced investment - as prices fall, more investment opportunities will be deemed unprofitable, as the real value of the borrowing to fund investment rises relative to the return
4) increased real cost of borrowing - borrowers will be paying more back (in real terms) on their debts. This means firms and consumers become reluctant to take on new debt
5) lower profit for firms - businesses are likely to face lower revenue and lower profits as prices fall, unless costs fall by more than prices, this may lead to unemployment as firms try reduce costs.
What are the possible benefits of inflation ?
- improves international-price-competitiveness - if other economies experience inflation, domestic products are more price competitive.
- possible increase in output - benign deflation could be beneficial, deflation from increase efficiency and lower costs of production can increase willingness and ability of firms to supply G+S, increasing real GDP
What are the evaluation points for deflation ?
1) rate of inflation - the extent to which prices are falling, a low rate of deflation is less harmful than a high rate of deflation
2) the duration of deflation - the longer deflation persists, the more likely the slowdown in economic activity and the longer the harmful effects of deflation are.
3) the cause of deflation - malign deflation is likely to be more harmful than benign deflation.
4) international trade effect - the extent to which the economy experiences the beneficial effects of an increase price-competitiveness
5) the level of indebtedness in the economy - the greater the level of existing debt, the more likely the decline in economic activity.
What is the nominal wage ?
Nominal wage - money paid as the reward to labour per period of time at current prices. The nominal wage rate does not take into account inflation
What is the wage-price spiral ?
What does the wage-price spiral look like in AD-SRAS model ?
What are the causes of hyper inflation ?
Though relatively uncommon, hyper inflation usually occurs due to uncontrollable inflationary expectations, fuelled by repeated expansions of the money supply, to meet spending commitments by government. And ongoing monetary expansion, this means consumers bring forward purchases and firms raising prices, leading to wage price-spirals.
When the government try to increase wages in-line with inflation, they may face difficulty borrowing, therefore they instruct the central bank to print more money to pay workers, the sustained monetary expansion accelerates Inflation even further, leading to hyper inflation.
What are the consequences of hyperinflation ?
- rapid fall in real incomes means that consumers are unable to afford necessities such as food. Rapid rise in the cost-of-living leads to rapid determination of standards of living
- cash and assets held in domestic currency become worthless
- ‘capital flight’: assets worth value in foreign currency, leave the economy
- inward FDI completely disappear
- alternative forms of exchange, such as barter, become more common.
What are policies to reduce inflation ?
Depends on the cause of inflation:
if inflation is mainly caused by demand-pull inflation AD needs to be reduced:
- contractionary fiscal policy, increased taxation, decrease government spending
- contractionary monetary policy, increase interest rates, tighter control on Money supply
If inflation is mainly cost-push:
- supply side policies to increase efficiency of markets, increasing productive capacity, this helps to address inflation irrespective of the cause by increasing productivity
