3.3.3 - Macroeconomic Objectives - Inflation and Deflation

Question 1

Define inflation

Answer 1

Inflation is the sustained increase in the general level of prices in an economy.

Question 2

Define disinflation

Answer 2

Disinflation is the fall in the rate of inflation in an economy. This means the rate at which the general level of prices is increasing falls.

Question 3

Define deflation

Answer 3

Deflation is the sustained decrease in the general level of prices in an economy.

Question 4

List 6 problems with measuring inflation

Answer 4

• Average consumer - consumers of different types have different rates of inflation
• Regional variation - Inflation rates
• Types of retailers - Price data varies from
• Change in the quality of goods
• Variations between countries - different countries use different measures of inflation
• One-off changes in price - Significant one-off changes in the price of a highly weighted good in the index can distort the inflation rate such as a big rise in energy prices.

Question 5

Define demand-pull inflation

Answer 5

Demand-pull inflation occurs when a rise in aggregate demand in the economy causes (pulls) the price level in the economy to increase.

Question 6

Graph demand pull inflation

Answer 6

Question 7

Outline the 4 factors causing demand pull inflation

Answer 7

• Reduced interest rates
• Rising house prices
• High levels of business and consumer confidence
• Expansionary fiscal policy

Question 8

Graph cost push inflation

Answer 8

Question 9

Outline the 4 factors causing cost push inflation

Answer 9

• Wage push inflation
• Raw material costs
• Capital costs
• Entrepreneurial profit

Question 10

Explain wage-price spiral

Answer 10

A wage-price spiral occurs when rising prices lead to higher wage demands from workers which in turn leads to higher prices and higher wage demands.

Question 11

Depreciating exchange rate

Answer 11

When a country’s exchange rate depreciates this leads to rising import prices which causes cost-push inflation.

Question 12

List the 6 effects of inflation

Answer 12

• Falling real incomes - Falling real incomes occur when the price level in the economy rises faster than the increase in household incomes.
• Borrowers and lenders - inflation means the real value of money repaid by borrowers is worth less than the money they borrowed from lenders.
• Investment - higher interest rates which come with high inflation, meaning the cost of borrowing for investment increases.
• Reduced international competitiveness - When a countries inflation rate is higher than its international competitors, the countries firms become less competitive.
• Business costs - An increase in the rate of inflation means that firms have to spend time changing prices as their costs increase. This represents an additional cost to businesses.
• Allocative efficiency - The price mechanism is the signalling and incentive system in the economy that guides the efficient allocation of resources. In countries with high inflation, the signalling and incentive functions of price do not work effectively and resources will not be allocated as efficiently.

Question 13

Illustrate demand-side deflation

Answer 13

Question 14

Illustrate supply-side deflation

Answer 14

Question 15

List 5 consequences of deflation

Answer 15

• Reduced growth and recession - if caused by falling AD
• Falling current consumption - households put off buying goods as they wait to buy them at even lower prices
• Redistribution of income - lenders gain at the expense of borrowers
• Rising spending power - supply side inflation means households have rising real incomes
• International competitiveness - If the price of goods fall relative to another country, competitiveness increases.