4.8 inflation and deflation

Question 1

Def of inflation

Answer 1

Overall increase in price levels related to declining value of a currency

Question 2

Def of deflation

Answer 2

Overall decrease in price levels related to increase value of a currency

Question 3

What are the 2 causes of inflation

Answer 3

Demand pull
Cost push

Question 4

What is demand pull inflation

Answer 4

rises in the price level caused by excess demand

Question 5

What is cost push inflation

Answer 5

rises in the price level caused by higher costs of production

Question 6

What are the consequences of inflation

Answer 6

Lower purchasing power
Exports are less internationally competitive
Inflation causing inflation
Fixed income groups, lenders, and savers lose

Question 7

Why is there lower purchasing power in periods of inflation

Answer 7

the higher the price levels rise, the lesser number of goods and services you can buy with the same amount of money

Question 8

Explain why Exports are less internationally competitive

Answer 8

lower priced foreign goods will rival it

Question 9

How does inflation cause inflation

Answer 9

cost of living in the economy rises
workers to demand higher wages
Cost of production increases
Price levels increase

Cycle

Question 10

Why do fixed income groups lose

Why do lenders lose?

Why would savers lose (if any loss)

Answer 10

Purchasing power of money falls. Fixed income group people can’t ask for an increase.

Lenders only get the same amount of money they lent before inflation, but the purchasing power has gone down and hence the value has gone down.

Savers also lose because the interest they’re earning on savings in banks does not increase as much as the inflation, and savers will lose the value on their money.

Question 11

What policies are employed to reduce inflation

Answer 11

Contractionary monetary policy
Contractionary fiscal policy
Supply side policies

Question 12

How does contractionary monetary policy reduce inflation

Draw backs

Answer 12

Increasing interest rates
Saving is encouraged
Spending and investing is reduced (more expensive to borrow)

Reduces the money supply in the economy

Spending and investing may still continue to rise as confidence remains high. There is also a considerable time lag for monetary policy to take effect.

Question 13

How does contractionary fiscal policy reduce inflation

when is this employed

Answer 13

Increasing tax - reduces disposable income. Spending will reduce. cutting down on government spending will reduce aggregate demand

when inflation is severe

Question 14

How do supply side policies reduce inflation

drawback

Answer 14

Aim to make firms competitive and efficient, and thus avoid inflationary pressures. Eg deregulation and privitisation

Long run only. Cannot correct short term inflationary pressure.

Question 15

How do supply side policies reduce inflation

drawback

Answer 15

Aim to make firms competitive and efficient, and thus avoid inflationary pressures. Eg deregulation and privatization

Long run only. Cannot correct short term inflationary pressure.

Question 15

How do supply side policies reduce inflation

drawback

Answer 15

Aim to make firms competitive and efficient, and thus avoid inflationary pressures. Eg deregulation and privatization

Long run only. Cannot correct short term inflationary pressure.

Question 16

What are the causes of deflation

Answer 16

Aggregate supply exceeding aggregate demand
Labour productivity has risen:
Technological advance

Question 17

What happens when Aggregate supply exceeding aggregate demand

Answer 17

excess of output in the economy not consumed, causing prices to fall.

Question 18

Why is there deflation if there is increased productivity and technological advance

Answer 18

Higher output
Lower average costs
reduced cost of production

Leads to deflation

Question 19

What are the consequences of deflation

Answer 19

unemployment - production may get discouraged

Investors are discouraged to invest because of falling demand/prices

Can cause recession - firms are forced to close down as enough profits are not being made.

Tax revenues of govts fall

Borrowers are at a loss since value of the debt they owe is higher than when they borrowed the money.

Question 20

What are the policies to control deflation

Answer 20

Expansionary monetary policy
Expansion fiscal policy
Devaluation
Change inflation expectations

Question 21

How would expansionary monetary and fiscal policy control deflation

draw backs

Answer 21

Monetary - Increased spending, low saving
drawback - liquidity trap

Fiscal - cutting direct taxes and increasing govt spending. Money can be raised through quantitative easing.

Question 22

What is a liquidity trap

what does it render ineffective

Answer 22

Contradictory economic situation where interest rates are low but savings are still high. Renders expansionary monetary policy ineffective.

Question 23

How does devaluation control deflation

Answer 23

export prices to fall, encouraging production of exports, resulting in higher demand;

Increase prices of imported products which will raise costs and prices for products in the economy.

Question 24

How would changing inflation expectations control deflation

Answer 24

People expecting deflation causes deflation. businesses won’t increase wages and consumers won’t pay higher prices (because they expect prices to fall in the future).

But if govt changes these expectations to inflation in the future then deflation can be avoided

Question 25

What is the Wage-price spiral

Answer 25

wage rises leading to higher prices, in turn, lead to further wage claims and price rises