3.3 Inflation And Deflation Flashcards
Inflation definition
The sustained rise in the general price level over time
Deflation definition
A fall in the average level of prices over time
Disinflation definition
Where the rate of inflation is falling but is still positive
What are the two causes of inflation?
- demand pull inflation
- cost push inflation
Demand pull inflation definition
Inflation caused by excessively high levels of aggregate demand, where there is pressure on resources
Why does demand pull inflation occur?
When are you demand is growing and substrain ability there is pressure on resources to produce increase their prices and earn more profits
What causes demand pull inflation?
Any change to AD that shifts AD in excessively
Cost push inflation definition
Inflation that occurs due to rises in the cost of production incurred by firms
Why do firms increase their prices due to cost push inflation?
Higher cost of production means less profit margin unless they increase their prices
What two things does cost push inflation lead to and why?
- inflation as firms rise there prices to maintain profit
- falling growth as increase cost of production shift SRAS left
Quantity theory of money definition
A alternative explanation for inflation which states that the only cause of inflation is excessive growth in the money supply
Fisher equation
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 )
Velocity of circulation definition
The rate at which money circulates around the economy
What is the main theory of the Quantity theory of money?
Monetarist state that there is inflation if money supply increases at a faster rate the national income
What does PQ mean?
Price level x quantity of real food sold
= nominal national income
What assumption do we make about V (velocity of money)?
It is constant
Chain of reasoning for quantity theory of money
- 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
Consequences of inflation to consumers
- 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
Shoe leather costs definition
The costs in time and money involved in making price comparisons
Fiscal drag definition
Taxpayers pulled into a higher tax band despite incomes not rising in real terms
Consequences of inflation for firms
- 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
Consequences of inflation for governments
- government have to increase welfare payments and state pension because cost of living is increasing
Why are there higher interest rates during periods of inflation?
The government implements deflationary polices which are usually higher interest rates
Menu costs definition
The cost associated with updating the changes in price over time
What are the two types of deflation?
Benign/good deflation
Malevolent/bad deflation
Benign deflation definition
A fall in the price level due to increases in aggregate supply
(usually due to falling costs of production)
Malevolent deflation definition
A fall in the price level due to a fall in aggregate demand
Why is benign deflation good?
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
Why is malevolent deflation bad?
A fall in aggregate demand lead to falling prices and falling real GDP
= negative multiplier
Consequences of deflation
- 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
Why do incomes fall during deflation?
Incomes fall to maintain real incomes
Commodity definition
A homogenous product that is often used as a basic input into production e.g. oil, copper ect
Why do you commodities have a significant effect on inflation rate?
Due to their importance in production
Open economy definition
An economy in which foreign trade accounts for significant proportion of its GDP
How does inflation effect being in an open economy?
Changes in other economies can affect inflation in the UK
