4.11.3 - Inflation and Deflation

Question 1

Give a brief history of inflation and deflation in the UK.

Answer 1

• 1970s - accelerating rates of inflation
• 1980s - monetarist policy, control of inflation elevated to highest salience in government macroeconomic policy (1980 inflation rate = 20%)
• 1990s - UK inflation rate remained within 1% of 2% target set from 1993 to 2007
• 2000s - UK inflation rate remained within 1% of 2% target set from 1993 to 2007, 2008 credit crunch and escalating oil, gas, food and commodity prices, rate of inflation began to fall and deflation was expected
• 2010s - Inflation quite steady
• 2020s - Inflation high by 2023

Question 2

What does a deflationary policy do?

Answer 2

Take excess demand out of the economy by fiscal/monetary policy.

Question 3

What is demand-pull inflation?

Answer 3

A rising price level caused by an increase in AD.

Question 4

What is cost-push inflation?

Answer 4

A rising price level caused by an increase in costs of production.

Question 5

How can firms be persuaded to produce more output?

Answer 5

Increasing the price level.

Can be done by increasing AD (and any of its components) which may create the extra demand which pulls up the price level.

Question 6

How can demand-pull inflationary pressures be offset?

Answer 6

A shift of the LRAS to the right.

Question 7

What happens when AD shifts right when the economy is producing its normal capacity?

Answer 7

Increased long run demand-pull inflation with no increase in real output.

Question 8

When does reflation give way to inflation?

Answer 8

When the AD curve is to the right of where the gradient of the SRAS curve is >1.

Question 9

Why did the theories of cost-push inflation develop?

Answer 9

In the Keynesian era of 1960s/70s, the rate of inflation increased even when there was little evidence of excess demand in the economy.

Question 10

What do cost-push theories generally argue as to the causes of inflation?

Answer 10

The growth of monopoly power in the labour market and its markets for goods and services.

Question 11

How did monopoly power cause inflation in the Keynesian era?

Answer 11

Trade unions became more powerful, and were able to bargain for money wage increases in excess of any rise in labour productivity.

Monopoly firms were willing to pay these wage increases due to the costs of disrupting production and because they can pass on increasing costs as price rises.

Question 12

Why must the government determine what causes inflation?

Answer 12

So the policies they implement are best to tackle either cost-push or demand-pull inflation.

Question 13

Why does monetary policy tend to work to control inflation?

Answer 13

Assuming excess AD causes inflation, monetary policy can control inflation.

Question 14

Why may monetary policy stop working to control inflation?

Answer 14

When there is cost-push inflation (possibly from imported energy or commodities).

Question 15

What is narrow monetarism?

Answer 15

Centres on increases in the money supply as the prime cause of inflation.

Question 17

Who are monetarists?

Answer 17

Economists who argue that a prior increase in the money supply is the cause of inflation.

Question 18

What do monetarists argue that excess AD is caused by?

Answer 18

A prior increase in the money supply.

Question 19

What is the quantity theory of money?

Answer 19

The oldest theory of inflation, which states that inflation is caused by a persistent increase in the supply of money.

Question 20

How does the quantity theory of money work?

Answer 20

If there is an expansion of the money supply greater than the increase in real national output, households and firms will hold excess money balances which, when spent, pull up the price level.

Essentially, too much money chasing too few goods.

Question 21

What is the equation of exchange?

Answer 21

Money Supply * Velocity of circulation of money = Price level * Quantity of output

MV = PQ

Question 22

What is the velocity of circulation?

Answer 22

The rate at which money circulates around the economy when people use money to buy goods.

Question 23

What is the disagreement about the velocity of circulation?

Answer 23

Monetarists argue that velocity is constant/stable.
Keynesian economists argue that when M increases, it is partially absorbed by a slowdown in V.

Question 24

Why do Keynesian economists generally reject the quantity theory of money?

Answer 24

• The velocity of circulation is not constant.
• Under-full employment equilibrium.
• Reverse causation.

Question 25

Why does the velocity of circulation not being constant cause Keynesian economists to reject the quantity theory of money?

Answer 25

V represents how often money is spent.

Monetarists say that because money earns little to no interest, it is generally rational to spend quickly any extra money holdings and not to hold any idle money balances. Therefore, as the money stock in the economy changes, V will remain constant/stable.
Keynesians say that it is generally rational to assume that people will hold idle money balances as an idle wealth asset. Therefore, as the money stock in the economy increases, V will fall.

Question 26

Why does under-full employment equilibrium cause Keynesian economists to reject the quantity theory of money?

Answer 26

If there is spare capacity and unemployment in the economy, an increase in the money supply may increase real income and output rather than the price level.

Keynesians feel that market forces are too weak and take too long to return the economy to its normal capacity output.

Question 27

Why does reverse causation cause Keynesian economists to reject the quantity theory of money?

Answer 27

Keynesians believe that changes in the price level cause the money supply to change, not the other way around. As a result, inflation is caused by cost-push institutional factors in the real economy.

Essentially, the money supply accomodates itself to (as opposed to determining) the price level.

If a government tightly restricts the growth of money to try to stem inflation, the main effect would be that the current level of transactions cannot be financed, so real activity would fall, resulting in higher unemployment.

Question 28

What roles do expectations play in the inflationary process?

Answer 28

If people expect the rate of inflation to increase, they will behave in an inflationary manner now. Trade unions bargain for higher wages, employers raise prices in expectation etc.

If people expect the rate of inflation to fall, they will behave in a manner that causes inflation to fall.

Question 29

Why is inflation good for certain people?

Answer 29

Homeowners, governments and wage earners with strong bargaining power have done well out of inflation.

Inflation increasing will reduce the real value of accumulated debt for homeowners and governments. (Homeowners do best when house price inflation exceeds the general rate of inflation as the real value of houses increases while the real value of mortgages falls.)

Question 30

How did UK governments cut through inflation psychology?

Answer 30

Convincing people that inflation would remain low and around the target inflation rate of 2%, making it much easier to control inflation as a result.

Question 31

What are the two theories for how people form their expectations of the future?

Answer 31

• Theory of adaptive expectations
• Theory of rational expectations

Question 32

What is the difference between the theories of adaptive and rational expectations?

Answer 32

Adaptive theories focus on recent information.
Rational expectations use all of the other information available as well.

The monetarist view is that is is unrealistic to assume a rational economic agent forms expectations of future inflation based solely upon past or experienced inflation.

Question 33

What are the main disadvantages of inflation?

Answer 33

• Distributional effects
• Distortion of normal economic behaviour
• Breakdown in the functions of money
• Reduced international uncompetitiveness

Question 34

How are distributional effects a disadvantage of inflation?

Answer 34

Weaker social groups in society lose while those in strong bargaining positions gain. With rapid inflation, real rates of interest may be negative, so lenders are paying borrowers for the privilege of lending to them, and inflation acts as a hidden tax.

Question 35

How is distortion of normal economic behaviour a disadvantage of inflation?

Answer 35

Inflation can cause households to bring forward purchases and hoard goods if they expect inflation to increase.
Firms may move money away from productive investment to commodity hoarding.

Occurs when changes in relative prices are confused with a change in the general price level or inflation.

Question 36

How are breakdowns in the functions of money a disadvantage of inflation?

Answer 36

In severe inflation, money becomes less useful as a medium of exchange. In hyperinflation, money is completely replaced with a different currency or less efficient bartering.

Question 37

How is reduced international uncompetitiveness a disadvantage of inflation?

Answer 37

When inflation is higher than in competitor countries, exports increase in price. Lower growth and rising unemployment are likely to result.

Question 38

Why can deflation be a problem?

Answer 38

People may postpone ‘big-ticket’ purchases , expecting prices to fall more.

This may erode business confidence and trigger recession or deepen recession.

Question 39

Draw an example of good deflation.

Answer 39

Question 40

Draw an example of bad deflation.

Answer 40

Question 41

What is good deflation caused by?

Answer 41

Improvements in the economy’s supply side, reducing business costs of production.

Price level falls, but output and employment rise.

Question 42

What used to be the main factor for cost-push inflation?

Answer 42

Rising wage costs.

Question 43

What is now the main factor for cost-push inflation?

Answer 43

Price rises in imported goods such as food, energy and raw materials.

Question 44

How do changes in other countries affect UK globalisation?

Answer 44

• UK is a small part of a globalised system. When times are good in the world economy, the UK imports inflation from other booming economies. When times are bad in the world economy, the UK imports disinflation.
• The USA is the main countries that affect the UK price level. ‘When the USA sneezes, the world catches a cold’
• China is a close second, costs of production in China have begun to rise increasing the costs for consumers and increasing the costs of imports.
• Other external shocks (oil crisis in the 1970s, ‘08 financial crisis etc.)

Question 46

What is bad deflation caused by?

Answer 46

A collapse of AD, negative multiplier effects and possibly a credit crunch.