3.3 Inflation And Deflation

Question 1

Inflation definition

Answer 1

The sustained rise in the general price level over time

Question 2

Deflation definition

Answer 2

A fall in the average level of prices over time

Question 3

Disinflation definition

Answer 3

Where the rate of inflation is falling but is still positive

Question 4

What are the two causes of inflation?

Answer 4

• demand pull inflation

- cost push inflation

Question 5

Demand pull inflation definition

Answer 5

Inflation caused by excessively high levels of aggregate demand, where there is pressure on resources

Question 6

Why does demand pull inflation occur?

Answer 6

When are you demand is growing and substrain ability there is pressure on resources to produce increase their prices and earn more profits

Question 7

What causes demand pull inflation?

Answer 7

Any change to AD that shifts AD in excessively

Question 8

Cost push inflation definition

Answer 8

Inflation that occurs due to rises in the cost of production incurred by firms

Question 9

Why do firms increase their prices due to cost push inflation?

Answer 9

Higher cost of production means less profit margin unless they increase their prices

Question 10

What two things does cost push inflation lead to and why?

Answer 10

• inflation as firms rise there prices to maintain profit

- falling growth as increase cost of production shift SRAS left

Question 11

Quantity theory of money definition

Answer 11

A alternative explanation for inflation which states that the only cause of inflation is excessive growth in the money supply

Question 12

Fisher equation

Answer 12

M x V = P x Q

M is money supply
V is velocity of circulation
P the average price level
Q is real national output ( RNI )

Question 13

Velocity of circulation definition

Answer 13

The rate at which money circulates around the economy

Question 14

What is the main theory of the Quantity theory of money?

Answer 14

Monetarist state that there is inflation if money supply increases at a faster rate the national income

Question 15

What does PQ mean?

Answer 15

Price level x quantity of real food sold

= nominal national income

Question 16

What assumption do we make about V (velocity of money)?

Answer 16

It is constant

Question 17

Chain of reasoning for quantity theory of money

Answer 17

• increasing money supply = increase AD as more money to spend
• firms increase supply in the short run. A positive output gap occurs
• = more workers employed = more wages = increase in costs for firms = put up prices to keep profit margin
• inflationary pressure means the real value of money falls = less AD as money can buy less
• workers demand higher wages to make up for inflation = left shift in SRAS
• output of the economy returns to equilibrium but the price level is higher

Question 18

Consequences of inflation to consumers

Answer 18

• affects low and fixed incomes the most as money has less purchasing power so cost of necessities are more expensive
• loans that are not payment fixed will be cheaper to pay back
• search and shoe leather costs
• fiscal drag
• redundancies as firms try to cut costs

Question 19

Shoe leather costs definition

Answer 19

The costs in time and money involved in making price comparisons

Question 20

Fiscal drag definition

Answer 20

Taxpayers pulled into a higher tax band despite incomes not rising in real terms

Question 21

Consequences of inflation for firms

Answer 21

• menu costs
• higher interest rates due to inflation mean borrowing and investing are less attractive
• workers might demand higher wages which will increase cost of production
• less price competitive on a global scale = less exports
• unpredictable inflation will affect business confidence = less investment

Question 22

Consequences of inflation for governments

Answer 22

• government have to increase welfare payments and state pension because cost of living is increasing

Question 23

Why are there higher interest rates during periods of inflation?

Answer 23

The government implements deflationary polices which are usually higher interest rates

Question 24

Menu costs definition

Answer 24

The cost associated with updating the changes in price over time

Question 25

What are the two types of deflation?

Answer 25

Benign/good deflation

Malevolent/bad deflation

Question 26

Benign deflation definition

Answer 26

A fall in the price level due to increases in aggregate supply
(usually due to falling costs of production)

Question 27

Malevolent deflation definition

Answer 27

A fall in the price level due to a fall in aggregate demand

Question 28

Why is benign deflation good?

Answer 28

And increase in aggregate supply, either in the short run or in the long run will lead to a lower price level but also a higher level of real GDP

Question 29

Why is malevolent deflation bad?

Answer 29

A fall in aggregate demand lead to falling prices and falling real GDP
= negative multiplier

Question 30

Consequences of deflation

Answer 30

• delays in consumption as consumers believe prices will be lower in the future = AD falls = malevolent deflation increases future
• rising real value of debt
• wage rigidity leads to unemployment as wages are too high for the labour market to clear

Question 31

Why do incomes fall during deflation?

Answer 31

Incomes fall to maintain real incomes

Question 32

Commodity definition

Answer 32

A homogenous product that is often used as a basic input into production e.g. oil, copper ect

Question 33

Why do you commodities have a significant effect on inflation rate?

Answer 33

Due to their importance in production

Question 34

Open economy definition

Answer 34

An economy in which foreign trade accounts for significant proportion of its GDP

Question 35

How does inflation effect being in an open economy?

Answer 35

Changes in other economies can affect inflation in the UK