4.8 - Inflation and Deflation Flashcards
Calculating the cost of a basket of goods
Price x weighting (weighting is decimal precentage, e.g. 24% = 0.34)
Calculating CPI
(cost of basket / cost of basket in base year) x 100
to find percentage: -100
How do you calculate the taxed percentage on products?
(taxed quantity / total amount) x 100
Inflation
Inflation is the sustained increase in the general price level of goods/services in an economy
Deflation
Deflation occurs when there is a fall in the general price level of goods/services in an economy
Disinflation
Disinflation occurs when price growth slows down after a period of high inflation
Demand pull inflation
Demand pull inflation is caused by excess demand in the economy
* If any of the four components of rGDP increase, there will be an increase in the total demand in the economy leading to an increase in the general price level
rGDP
rGDP = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)
Example of demand pull inflation
- If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms & consumers
* This will result in an increase in consumption & investment which will increase the rGDP
Cost push inflation
Cost push inflation is caused by increases in the costs of production in an economy
* If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in productivity, the total supply will decrease
* With less supply, prices rise leading to an increase in the general price level
Example of cost push inflation
- Trade Unions negotiate higher wages for workers
- The wage increases represent an increased cost of production for firms
- With the inputs, firms now produce less & supply reduces leading to higher general price levels
How does inflation impact firms? (3)
- Uncertainty: Rapid price changes create uncertainty & delay investment
- Menu change costs: Price changes force firms to change their menu prices too & this can be expensive
- Lenders: Financial firms that lend money are worse off as the money lent out is now worth less than before
How does inflation impact consumers? (name 3)
- Purchasing Power: Decrease in purchasing power worsens their quality of life
- Savings: There is a decrease in the real value of savings (as money will be worth less in real terms)
- Real Income: There is a fall in real income for those on fixed incomes/pension
- Borrowers: anyone who borrows money benefits as the repayments are worth less than when the money was originally borrowed
How does inflation impact the government? (3)
- International Competitiveness: Inflation erodes international competitiveness of export industries as their products now look relatively more expensive to foreigners
- Trade-offs: They are involved in tackling inflation e.g reducing inflation may increase unemployment and/or reduce economic growth
- Government Debt: inflation erodes the value of government debt as the repayments are worth less than when the money was originally borrowed
How does inflation impact workers? (2)
- Higher Wages: Workers demand higher wages to compensate for reduced purchasing power
- Morale: If wage increases ≠ inflation, motivation & productivity may fall as workers do not receive the same real benefit for the work they are doing
Demand-side deflation (bad deflation)
Demand-side deflation is caused by a fall in total (aggregate) demand in the economy
* If any of the four components of rGDP decrease, there will possibly be a decrease in the total demand in the economy leading to a decrease in the general price level
Supply-side deflation (good deflation)
Supply-side deflation is caused by increases in the productive capacity of the economy
* This is brought about by any increase in the quantity/quality of the factors of production
* It effectively creates a condition of excess supply in the economy
* General price levels fall
* National output (rGDP) increases
Consequences of demand-side deflation (name 3)
- With a decrease in output, fewer workers are required & so unemployment increases
- With falling output & rising unemployment, households lose confidence choosing to save instead of spend. Consumption falls & rGDP reduces even more
- Debt feels more burdensome as the value of any debt is worth more. Real cost of borrowing increase as real interest rates rise when the price level falls
- Falling output & falling prices cause firms to lose confidence & so they delay investment, further reducing rGDP
- Falling output & falling prices reduce the profits of firms. Some firms will be unable to continue & will go out of business
- Persistently falling prices can prove attractive to foreigners & the level of exports may increase (this helps offset some of the reduction in rGDP)
Consequences of supply-side deflation (name 3)
- With a decrease in costs, the output of firms increases. More workers are required & so unemployment falls
- With rising output & falling price levels, households become more confident & consumption increasing - increasing rGDP even more
- Debt still feels more burdensome as the value of any debt is worth more
- Rising output & falling costs of production cause firms to gain confidence & increase investment, thereby increasing rGDP
- Persistently falling prices boosts international competitiveness & exports increase
How can demand-pull inflation be tackled?
Using contractionary demand-side policies (monetary or fiscal)
How does contractionary fiscal policy reduce demand-pull inflation?
- Government increases corporation tax: Firms pay more tax → firms have less profit → firms invest less → rGDP falls → inflation decreases
- Government decreases expenditure on national defence: Government spending decreases → defence firms receive fewer orders from the government → national output falls → inflation decreases
- Government increases personal income tax: Households have less discretionary income → consumption decreases → national output falls → inflation decreases
How does contractionary monetary policy reduce demand-pull inflation?
- The Central Bank increases interest rates: Household repayments on existing loans rise → households have less discretionary income → consumption decreases → national output falls → inflation decreases
- The Central Bank decreases the money supply by stopping quantitative easing: Firms receive less money from the sale of bonds → investment decreases → national output falls → inflation decreases
How do supply-side policies reduce cost push inflation? (3)
- The Government reduces regulation on the oil & banking industries: Regulations removed → costs of production decrease as firms no longer need to spend money meeting requirements → national output (total supply) rises → inflation reduces
- The Government changes migration policies to allow more workers into the country: More workers move into the country → the price of labour (wages) falls → costs of production reduce for firms → national output (total supply) rises → inflation reduces
- The Government builds a new rail network serving ports & airports: Speed & capacity of transport infrastructure is improved → costs of production decrease as firms benefit from the improvements → national output (total supply) rises → inflation reduces
How can cost push inflation be tackled?
Using supply-side policies
How can deflation be tackled?
Using expansionary demand-side policies (fiscal and monetary)
How do expansionary fiscal policies reduce deflation? (2)
- Government increases expenditure on national defence: Defence firms receive more orders from the government → total demand increases → deflation is improved/eliminated
- Government decreases personal income tax: Households have more discretionary income → consumption increases →total demand increases → deflation is improved/eliminated
How does expansionary monetary policy reduce deflation? (1)
The Central Bank lowers interest rates: Household repayments on existing loans fall → Households have more discretionary income → consumption increases → total demand increases → deflation is improved/eliminated
