4.2.3.3 inflation and deflation Flashcards
define inflation
and what’s the macroeconomic objective number?
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%
RECAP
we can measure inflation with the consumer price index (CPI)
what is this?
- 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
what are some limitations of the CPI?
- 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
RECAP
what is CPIH?
CPI plus owner-occupier housing costs (the amount you would have to pay to rent a property) and council tax
RECAP
what is the retail price index (RPI)?
- 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 been replaced by CPIH but is still used
what happens with demand-pull inflation?
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
what are the main triggers for demand pull inflation?
- 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
how do you illustrate demand pull inflation on a diagram and explain it?
in the short run, if D for goods and services rises faster than firms can provide additional supply
- prices are ‘pulled upwards’
what happens with cost-push inflation?
- 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
what can cause cost push inflation?
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
how do you illustrate cost push inflation on a diagram?
what is the quantity theory of money?
if the growth of the money supply increases at a faster rate than national income - this leads to inflation
what do monetarists say about increases in prices?
are caused solely by increases in the money supply
what did Milton Friedman say about inflation?
‘inflation is always and everywhere a monetary phenomenon’
what is the fisher equation?
what do each of the four components stand for?
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
what do monetarists argue about V and Q?
argue that V and Q are constant (in terms of their impact on price)
what do M and V make up in the economy?
what method do they give us to work out nominal GDP?
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
what do P and Q make up in the economy?
what method do they give us for working out nominal GDP?
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
why must MV always be equal to PQ?
- MV = what’s brought
- PV = has to be sold to someone
therefore the two have to be equal
how do we rearrange the equation to isolate the impact of price?
P = MV / Q
only M can influence price
why?
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
what are some problems with the quantity theory of money?
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
how do you increase the money supply?
- 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
what is liquidity?
how easy it is and quickly it takes to turn financial assets into money
- notes and coins are very liquid
- a house = illiquid
what is quantitative easing?
- 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
what are bonds?
fixes income financial assets that provide the holder with a stream of income on an annual basis
what is the total quantitive easing figure of:
NOV 2009
JULY 2012
AUG 2016
MARCH 2020?
NOV 2009 - £200bn
JULY 2012 - £375bn
AUGUST 2016 - £435bn
MARCH 2020 - £645bn
how does quantitive easing impact the economy?
how do governments borrow?
what is the wealth effect?
lower yields (interest rates) lead to higher share and bond prices
what is the borrowing cost effect?
QE lowers the interest rate on long term debt such as government bonds and mortgages
what is the lending effect?
QE increases the liquidity of banks and increased lending from banks lifts incomes and spending in the economy
what is the currency effect?
lower interest rates has the side effect of causing the exchange rate to weaken (a depreciation) which helps exports
what is the cost of inflation to consumers?
- 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
what is the cost of inflation to firms?
- 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
what is the cost of inflation to the government?
the government will have to increase the value of the state pension and welfare payments, because the cost of living is increasing
what is the cost of inflation on workers?
- 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
what are the general costs of inflation?
- 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
what are some benefits of inflation?
- sustainable rate of inflation suggests growth
- reduced risk of deflation
- erodes the real value of debts
what is deflation?
decrease in the general price level
there is a negative inflation rate
what are the consequences of deflation?
- 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
what is disinflation?
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
what is hyper inflation?
- large increases in the general price level
- when the store of value function of money fails to hold
what is creeping inflation?
slow rises in prices over a number of years
what is benign deflation?
prices falling due to improvements in productivity which lowers costs
what is malign deflation?
- bad
- caused by persistent low levels of aggregate demand
how do changes in world commodity prices affect domestic inflation?
- 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
how can changes in other economies affect inflation in the UK?
- 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
