4.2.3.3 Inflation and Deflation

Question 1

What is inflation?

Answer 1

• A rise in the average price level
• A fall in the value of money
• A rise in the cost of living

Question 2

What is deflation?

Answer 2

A fall in average price level

Question 3

What is disinflation?

Answer 3

When prices are rising but at a slower rate

Question 4

What is Hyperinflation

Answer 4

Very high level of inflation. Eg. Zimbabwe

Question 5

What is demand-pull inflation?

Answer 5

• Inflation caused by rising AD when the economy is close to full capacity.
• i.e. rising consumer or business confidence, expansionary monetary or fiscal policy, a fall depreciation in the value of the £.

Question 6

What is cost-push inflation?

Answer 6

• Inflation caused by rising costs of production. e.g.
• Rising wage costs in the labour market, increasing raw material costs, rising import prices, declining productivity, higher VAT.

Question 7

Why might Brexit cause cost push inflation?

Answer 7

The falling value of the £ causes a rise in import costs, causing cost-push inflation.

Question 8

Why are price expectations important in determining inflation?

Answer 8

• If businesses expect prices to rise then they may put them up in anticipation of price rises. If employees expect inflation to rise they may demand higher wages and this will cause cost-push inflation.
• High inflationary expectations may be self-fulfilling i.e. cause inflation

Question 9

Why might inflation cause more inflation?

Answer 9

• If there is inflation for goods and services then labour may demand higher wages to compensate for this.
• Higher wages can cause more inflation through cost-push inflation ( a wage-price spiral)

Question 10

CPI rises from 2360 to 2368. What is the rate of inflation?

Answer 10

8/2360 x 100 = 0.34%

Question 11

What is the consequence of inflation for individuals (Savers)

Answer 11

• For savers the value of their money in savings is devalued, Inflation erodes the value.
• The savings gradually buy less or fall in real terms.
• If prices are rising constantly consumers may have to spend more time looking for the items with the best price. (shoe leather costs)

Question 12

What is the consequence of inflation for individuals (Borrowers)

Answer 12

For borrowers it is generally good, it reduces the value of their debt

Question 13

What is the consequence of inflation for individuals (Those on fixed incomes)

Answer 13

For anyone on fixed incomes their real income falls.

Question 14

What is the consequence of inflation for the economy as a whole (the functioning of the price mechanism)

Answer 14

• Inflation distorts the price mechanism-With inflation, the price mechanism cannot effectively fulfil its role as a resource allocating mechanism.
• The distortionary effect is called inflation noise which can occur when consumers and producers misperceive relative prices and costs.
• The effect is most significant when the rate of inflation is excessive.

Question 15

What is the consequence of inflation for the economy as a whole (international competitiveness)

Answer 15

Decline in competitiveness. Higher inflation can make firms less competitive internationally, leading to lower exports and deterioration in the current account (or depreciation in the exchange rate).

Question 16

What is the consequence of inflation for economy as a whole (uncertainity and investment)

Answer 16

• Less investment. If inflation is high, firms will reduce investment due to uncertainty, leading to low economic growth.
• Periods of low inflation, on the other hand are beneficial for promoting investment and economic growth.

Question 17

What is the consequence of inflation for economy as a whole (fiscal drag)

Answer 17

• Fiscal drag is a concept where inflation and earnings growth may push workers into higher tax brackets.
• Therefore fiscal drag has the effect of raising government tax revenue without explicitly raising tax rates.

Question 18

What is the consequence of inflation for economy as a whole (economic policy)

Answer 18

The bank of England may put up interest rates to curb inflation. This will cause AD to fall

Question 19

What is malign deflation?

Answer 19

• Malign deflation occurs when prices fall because of falling aggregate demand
• This is the worst kind of deflation as it is accompanied by increasing unemployment and negative growth.

Question 20

What is benign deflation?

Answer 20

• Deflation is caused by rising productivity, falling costs of production or improved production technology.
• This is less harmful because it is associated with economic growth.

Question 21

What are the consequence of deflation for individuals (savers, borrowers, those on fixed incomes)

Answer 21

• Savers do well. The real value of savings increases. Borrowers lose out. The real value of fixed incomes rises.

Question 22

What is the consequence of deflation for the economy as a whole.

Answer 22

• In terms of ‘good’ deflation / benign, it can actually help an economy.
• Malign has the opposite effect as it purely creates more decreases in confidence and unemployment.
• DEFLATION IS GENERALLY CONSIDERED BAD BECAUSE CONSUMERS POSTPONE CONSUMPTION IN THE HOPE OF CHEAPER PRICES.
• AGGREGATE DEMAND FALLS AND ECONOMIES WITH DEFLATION E..G JAPAN GET STUCK IN RECESSION.

Question 23

How might changes in commodity prices affect domestic inflation?

Answer 23

Rising commodity prices lead to cost-push inflation. Firms face higher input costs and pass these costs onto consumers.

Question 24

How can changes in other economies affect UK inflation?

Answer 24

• Growth in our major trading partners may increase the demand for our exports.
• This leads to an increase in aggregate demand and potential demand-pull inflation.

Question 25

Why is the inflation target 2% in the UK?

Answer 25

• Not too high and not too low- makes it more stable.
• It is compatible with sustainable growth. It avoids the problems of deflation and the costs excessive inflation