3.3 Inflation and Deflation

Question 1

Define inflation

Answer 1

• Inflation is the sustained increase in the general price level over time.
• This means that the cost of living increases and the purchasing power of money decreases.

Question 2

Define deflation

Answer 2

• Deflation is the sustained decrease in the average price level in the economy.
• There is a negative inflation rate.

Question 3

Define disinflation

Answer 3

• Disinflation is the falling rate of inflation.
• This is when the average price level is still
  rising, but to a slower extent.
• This means goods and services are relatively cheaper now than a year ago, and the purchasing power of money has increased.
• Deflationary government policies aim to reduce AD, and do not necessarily result in deflation.

Question 4

What are the main causes/types of inflation?

Answer 4

• Demand pull inflation
• Cost push inflation

Question 5

What is demand pull inflation?

Diagram AD shifting right with SRAS

Answer 5

• This is caused by excess demand in the economy
• When aggregate demand is growing unsustainably, there is pressure on resources.
• Producers increase their prices and earn more profits. It usually occurs when resources are fully employed.

Question 6

What are the main triggers for demand pull inflation?

Answer 6

• A depreciation in the exchange rate, which causes imports to become more expensive, whilst exports become cheaper-this causes AD to rise.
• Fiscal stimulus in the form of lower taxes or more government spending (budget deficit)
  -This means consumers have more disposable income, so consumer spending increases and may spiral out of control
• Lower interest rates makes saving less attractive and borrowing more attractive, so consumer spending increases.
• High growth in UK export markets means UK exports increase and AD increases

Question 7

What is cost push inflation?

SRAS shifting left

Answer 7

• from the supply-side of an economy and is caused by increases in the costs of production in an economy

Question 8

What are the causes of cost push inflation?

Answer 8

• Changes in world commodity prices can affect domestic inflation.
  -For example, raw materials might become more expensive if oil prices rise-this increases costs of production.
• Labour becomes more expensive-this could be through trade unions, for example.
• Expectations of inflation- if consumers expect prices to rise, they may ask for higher wages to make up for this, and this could trigger more inflation.
• Indirect taxes could increase the cost of goods such as cigarettes or fuel, if producers choose to pass the costs onto the consumer.
• Depreciation in the exchange rate, which causes imports to become more expensive and pushes up the price of raw materials.
• Monopolies, using their dominant market position to exploit consumers with high prices.

Question 9

What are the effects of inflation on consumers?

Answer 9

• Those on low and fixed incomes are hit hardest by inflation, due to its regressive effect, because the cost of necessities such as food and water becomes expensive. -
• The purchasing power of money falls, which affects those with high incomes the least.
• If consumers have loans, the value of the repayment will be lower, because the amount owed does not increase with inflation, so the real value of debt decreases.

Question 10

What are the effects of inflation on firms?

Answer 10

• Low interest rates means borrowing and investing is more attractive than saving profits.
• With high inflation, interest rates are likely to be higher, so the cost of investing will be higher and firms are less likely to invest.
• Firms might face more menu costs-constantly changing prices to keep up with inflation which can be expensive
• Workers might demand higher wages, which could increase the costs of production for firms.
• Firms may be less price competitive on a global scale if inflation is high.
  -This depends on what happens in other countries, though.
• Unpredictable inflation will reduce business confidence, since they are not aware of what their costs will be.
  -This could mean there is less investment.

Question 11

What are the effects of inflation of the government?

Answer 11

• The government will have to increase the value of the state pension and welfare payments, because the cost of living is increasing.
• Erodes international competitiveness
• Trade-offs involved in tackling inflation, e.g reducing inflation may increase unemployment and/or reduce economic growth

Question 12

What are the effects of inflation on workers?

Answer 12

• Real incomes fall with inflation, so workers will have less disposable income.
• If firms face higher costs, there could be more redundancies when firms try and cut their costs.

Question 13

What are the main types of deflation?

Answer 13

• Demand-side deflation (bad deflation)
• Supply-side deflation

Question 14

What is demand side deflation?

Diagram AD shift left with SRAS

Answer 14

• ## It is caused by a fall in total (aggregate) demand in the economy

Question 15

What is supply-side deflation?

SRAS shifting right

Answer 15

• is caused by increases in the productive capacity of the economy
• this is brought about by any increase in the quantity/quality of the factors of production
• It effectively creates a condition of excess supply in the economy and the average price levels fall whilst national output (rGDP) increases

Question 16

What are the consequences of demand-side deflation?

Answer 16

• Government Challenges:With a decrease in output, fewer workers are required and so unemployment increases, Fiscal and monetary policy is less effective at combating deflation than inflation as consumers get into a habit of waiting for lower prices prior to making purchases
• Consumers Lose Confidence: With falling output and rising unemployment, households lose confidence choosing to save instead of spend
  -Consumption falls and rGDP reduces even more
  -Consumers delay purchasing goods/services as they believe prices will be cheaper in a few weeks or months
• Firms Lose Confidence:Falling output and falling prices cause firms to lose confidence and so they delay investment, further reducing rGDP
• Debt: Debt feels more burdensome as the value of any debt is worth more-the real cost of borrowing increases as real interest rates rise when the price level falls
• Bankruptcies:Falling output and falling prices reduce the profits of firms-some firms will be unable to continue and will go out of business
• Export: Persistently falling prices can prove attractive to foreigners and the level of exports may increase (this helps offset some of the reduction in rGDP)

Question 17

What are the consequences of supply-side deflation?

Answer 17

• Unemployment falls: With a decrease in costs, the output of firms increases. More workers are required and so unemployment falls
• Consumers Gain Confidence:With rising output and falling price levels, households become more confident and the consumption increasing, increasing rGDP even more
• Firms Gain Confidence:Rising output and falling costs of production cause firms to gain confidence and increase investment, thereby increasing rGDP
• Exports: Persistently falling prices boost international competitiveness and exports increase
• Debt: still feels more burdensome, as the value of any debt is worth more

Question 18

What is the quantity theory of money, give the equation?

Answer 18

• The Quantity Theory of Money states that there is inflation if the money supply increases at a faster rate than national income.
• Fisher’s equation of exchange is MV = PQ.

-M refers to the supply of money
-V is the velocity of circulation
-P is the price level
-Q is the quantity of real goods sold (real GDP)

• Therefore, the value of expenditure on goods equals the value of total output
  (MV=PQ).

Question 19

What does this equation assume about V and Q?

Answer 19

• The equation assumes that velocity is constant
• Q is independent of the supply of money
• Only supply-side factors affect Q
• It is assumed V is constant because the frequency that workers are paid does not change often.

Question 20

What does this equation depict?

Answer 20

• The equation argues that increasing the money supply causes inflation.
• When the money supply increases, consumers have more money to spend-this causes AD to shift to the right.
  -Firms then increase supply in the short run.
  -A positive output gap occurs, which is inflationary.
• As a result, more workers are employed, so wages increase-this means costs increase for firms, so they put up prices.
  -This inflationary pressure means the real value of money falls.
• Since money can buy less, there is a contraction in demand.
• Workers demand higher wages to make up for the increase in inflation-this leads to a left shift in the SRAS curve.
• The output in the economy returns to equilibrium, but the price level is higher.