4.2.3.3 inflation and deflation

Question 1

define inflation
and what’s the macroeconomic objective number?

Answer 1

rate of change in the average price level over time

also
- sustained increase in cost of living
- fall in the purchasing power of money

macroeconomic objective: inflation of 2%

Question 2

RECAP
we can measure inflation with the consumer price index (CPI)
what is this?

Answer 2

• family expenditure survey carried out to judge average spending habits
• regularly updated, representative basket of goods
• attaches weights to items based on importance in people’s spending

Question 3

what are some limitations of the CPI?

Answer 3

• households experience different rates of inflation
  -> eg) 14% of households don’t own a car, spending patterns are different depending on number in the family etc
• doesn’t recognise improvements in quality of goods and services
• slow to respond to new products

Question 4

RECAP
what is CPIH?

Answer 4

CPI plus owner-occupier housing costs (the amount you would have to pay to rent a property) and council tax

Question 5

RECAP
what is the retail price index (RPI)?

Answer 5

• includes mortgage interest repayments and Council Tax
• tends to be above the CPI
• excludes top and bottom 4% of the population
• discredited as a measure because mortgage payments distort the figure
  -> been replaced by CPIH but is still used

Question 6

what happens with demand-pull inflation?

Answer 6

from the demand side of the economy (AD)
- when AD is growing unsustainably, there’s pressure on resources
- producers increase their prices and earn more profits
- usually occurs when resources are fully employed

Question 7

what are the main triggers for demand pull inflation?

Answer 7

• reduced taxation
• lower interest rates
• increased confidence
  -> increases consumption and investment
• income increases
• availability of credit
• weak exchange rates
  -> will boost export growth + imports will be more expensive
• fast growth in other countries
  -> increase demand for UK exports

Question 8

how do you illustrate demand pull inflation on a diagram and explain it?

Answer 8

in the short run, if D for goods and services rises faster than firms can provide additional supply
- prices are ‘pulled upwards’

Question 9

what happens with cost-push inflation?

Answer 9

• this is from the supply side of the economy
• occurs when firms face rising costs
• firms respond to rising costs of production by increasing prices

Question 10

what can cause cost push inflation?

Answer 10

1) changes in world commodity prices can affect domestic inflation
- eg) raw materials might become more ££ if oil prices rise
-> this increases costs of production

2) labour becomes more expensive
- could be through trade unions, for example

3) expectations of inflation
- if consumers expect prices to rise, they may ask for higher wages to make up for this
- this could trigger more inflation

4) indirect taxes could increase the cost of goods like cigs or fuel, if producers choose to pass the costs onto the consumer

5) depreciation in the exchange rate, which causes M to become more ££ and pushes up the price of raw materials

6) monopolies
- using their dominant market position to exploit consumers with high prices

7) higher taxes
- corporation, national insurance, waste disposal

Question 11

how do you illustrate cost push inflation on a diagram?

Answer 11

Question 12

what is the quantity theory of money?

Answer 12

if the growth of the money supply increases at a faster rate than national income - this leads to inflation

Question 13

what do monetarists say about increases in prices?

Answer 13

are caused solely by increases in the money supply

Question 14

what did Milton Friedman say about inflation?

Answer 14

‘inflation is always and everywhere a monetary phenomenon’

Question 15

what is the fisher equation?
what do each of the four components stand for?

Answer 15

MV = PQ

M = money supply
V = velocity of circulation
- ie. how many times money circulates around the economy, no. of times it changes hands

P = average price level - inflation
Q = quantity of goods / services sold (real GDP)
- national income / output / expenditure

Question 16

what do monetarists argue about V and Q?

Answer 16

argue that V and Q are constant (in terms of their impact on price)

Question 17

what do M and V make up in the economy?
what method do they give us to work out nominal GDP?

Answer 17

expenditure / consumption side of the equation

• total money supply in the economy x velocity of circulation, amount of times we use that money
• therefore gives us the total amount of spending taking place in the economy
• so it = the expenditure method to get nominal GDP

Question 18

what do P and Q make up in the economy?
what method do they give us for working out nominal GDP?

Answer 18

value of what’s sold in the economy

• quantity of goods and services sold in the economy x their current prices
• output method of calculating nominal GDP

Question 19

why must MV always be equal to PQ?

Answer 19

• MV = what’s brought
• PV = has to be sold to someone

therefore the two have to be equal

Question 20

how do we rearrange the equation to isolate the impact of price?

Answer 20

P = MV / Q

Question 21

only M can influence price
why?

Answer 21

monetarists say that V and Q are constant

therefore, only M can influence prices

• more money chasing the same quantity of goods means prices will increase to compensate this
• only changes in the money supply can lead to changes in the inflation rate

Question 22

what are some problems with the quantity theory of money?

Answer 22

there are other possible causes of inflation

1) changes in V
2) changes in Q
3) demand-pull and cost-push inflation
4) reverse causality
5) M difficult to quantify

Question 23

how do you increase the money supply?

Answer 23

• printing more notes through the Bank of England
• reducing deposit holdings of banks allowing them to lend more money
  (by law, banks in the UK must hold a certain % of deposits to provide liquidity)
• use quantitative easing

Question 24

what is liquidity?

Answer 24

how easy it is and quickly it takes to turn financial assets into money

• notes and coins are very liquid
• a house = illiquid

Question 25

what is quantitative easing?

Answer 25

• an unconventional form of monetary policy
  -> controlling the economy and exchange rates using interest rates / money supply
• has been used in a number of countries over the last 10yrs
  -> UK / USA / EU
• involves into of new money into the national supply by a central bank
• new electric money is used to buy assets (mainly bonds) from financial institutions such as:
  -> insurance companies
  -> pension funds
  -> commercial banks

Question 26

what are bonds?

Answer 26

fixes income financial assets that provide the holder with a stream of income on an annual basis

Question 27

what is the total quantitive easing figure of:
NOV 2009
JULY 2012
AUG 2016
MARCH 2020?

Answer 27

NOV 2009 - £200bn
JULY 2012 - £375bn
AUGUST 2016 - £435bn
MARCH 2020 - £645bn

Question 28

how does quantitive easing impact the economy?

Answer 28

Question 29

how do governments borrow?

Answer 29

Question 30

what is the wealth effect?

Answer 30

lower yields (interest rates) lead to higher share and bond prices

Question 31

what is the borrowing cost effect?

Answer 31

QE lowers the interest rate on long term debt such as government bonds and mortgages

Question 32

what is the lending effect?

Answer 32

QE increases the liquidity of banks and increased lending from banks lifts incomes and spending in the economy

Question 33

what is the currency effect?

Answer 33

lower interest rates has the side effect of causing the exchange rate to weaken (a depreciation) which helps exports

Question 34

what is the cost of inflation to consumers?

Answer 34

• those on low and fixed incomes are hit hardest by inflation
  -> due to its regressive effect, because the cost of necessities like food and water becomes expensive
• if consumers have loans, the value of repayment will be lower
  -> due to the amount owed not increasing with inflation, so the real value of debt decreases

Question 35

what is the cost of inflation to firms?

Answer 35

• low interest rates means borrowing + investing is more attractive than saving profits
  -> with high inflation, interest rates are likely to be higher
  -> so cost of investing = higher
  -> firms are less likely to invest
• workers might demand higher wages
  -> could increase the costs of production to firms
• firms may be less price competitive on a global scale if inflation is high
  -> depends on what happens in other countries though
• unpredictable inflation will reduce business confidence
  -> since they’re not aware of what their costs will be
  -> could mean there’s less investment

Question 36

what is the cost of inflation to the government?

Answer 36

the government will have to increase the value of the state pension and welfare payments, because the cost of living is increasing

Question 37

what is the cost of inflation on workers?

Answer 37

• real incomes fall with inflation, so workers have less disposable income
• if firms face higher cots, there could be more redundancies when firms try and cut their costs

Question 38

what are the general costs of inflation?

Answer 38

• reduced confidence and therefore investment
• real value of savings decreases
  -> disincentive to save
• income redistributed from savers to borrowers
  -> real value of savings falls and so does the real value of debt
• consumers and businesses on fixed income lose out
• harms trade (reduces UK competitiveness)
• wage-price spiral
• usually leads to higher interest rates
• menu costs and shoe leather costs

Question 39

what are some benefits of inflation?

Answer 39

• sustainable rate of inflation suggests growth
• reduced risk of deflation
• erodes the real value of debts

Question 40

what is deflation?

Answer 40

decrease in the general price level
there is a negative inflation rate

Question 41

what are the consequences of deflation?

Answer 41

• holding back on spending
  -> consumers expect prices to fall further so don’t deem buying the good today as necessary
• lower profit margins
• wealth decreases and hits confidence
  -> business investment can decrease

Question 42

what is disinflation?

Answer 42

when the inflation rare is positive but falling
ie) it’s a fall in the rate of inflation

prices are still rising but at a slower rate

Question 43

what is hyper inflation?

Answer 43

• large increases in the general price level
• when the store of value function of money fails to hold

Question 44

what is creeping inflation?

Answer 44

slow rises in prices over a number of years

Question 45

what is benign deflation?

Answer 45

prices falling due to improvements in productivity which lowers costs

Question 46

what is malign deflation?

Answer 46

• bad
• caused by persistent low levels of aggregate demand

Question 47

how do changes in world commodity prices affect domestic inflation?

Answer 47

• commodities (eg. oil and food) make up a large proportion of UK imports and therefore have a high impact on prices (imported inflation)
• imported commodities to UK are price inelastic
• therefore a rise in the world price of commodities feeds through to UK inflation

Question 48

how can changes in other economies affect inflation in the UK?

Answer 48

• emerging markets creating growing demand
  -> creates demand pull inflation
• increasing productive capacity in emerging markets leads to lower costs, therefore lower prices
• economic performance of major trading partners impacts on demand and therefore inflation