4.8 Inflation & Deflation

Question 1

Define inflation

Answer 1

The sustained increase in the price levels of goods/services in an economy over time

Question 2

What are the two main causes of inflation?

Answer 2

• Demand-pull: Aggregate demand exceeds aggregate supply, so prices increase
• Cost-push: Increase in costs of production, so prices increase

Question 3

Define deflation

Answer 3

The sustained decrease in the price levels of goods/services in an economy over time

Question 4

What are the two main causes of deflation?

Answer 4

• Demand-side: Decrease in aggregate demand (unemployment, reduced confidence, high interest, etc)
• Supply-side: Aggregate supply exceeds aggregate demand (increased productivity, lower costs, tech advancements, etc)

Question 5

How is inflation measured?

Answer 5

• Consumer Price Index (CPI)
• ‘Household basket’ of 700+ goods/services an average household would purchase calculated annually
• Goods/services weighted based on proportion of income spent on them
• Final value = price x weighting
• CPI = cost of basket in year X / cost of basket in base year x 100
• Percentage difference in CPI is the inflation rate

Question 6

What are the consequences of inflation for firms?

Answer 6

• Price changes –> uncertainty, delay investment
• Lenders worse off (repayments worth less than money lended)
• Menu prices must change, this is expensive

Question 7

What are the consequences of inflation for consumers?

Answer 7

• Decrease in purchasing power
• Decrease in value of savings
• Fall in real income
• Borrowers benefit (repayments worth less than money borrowed)

Question 8

What are the consequences of inflation for the government?

Answer 8

• Erodes international competitiveness (exports decrease)
• Decreasing inflation may increase unemployment/reduce economic growth (trade-offs)
• Erodes government debt (repayments worth less than money borrowed)

Question 9

What are the consequences of inflation for workers?

Answer 9

• Higher wages (demanded to compensate for reduced purchasing power)
• Wage rises do not match inflation –> morale/productivity falls (same work worth less)

Question 10

What are the consequences of demand-side deflation?

Answer 10

• Decrease in output –> unemployment
• Confidence lost, consumption/investment falls
• Burden of debt increases (repayments worth more than money borrowed)
• Reduced profits, bankruptcies
• Exports may increase (lower prices)

Question 11

What are the consequences of supply-side deflation?

Answer 11

• Decrease in costs, output increases, fall in unemployment
• Rising output & falling prices, confidence increases (consumption and investment increase)
• Burden of debt increases (repayments worth more than money borrowed)
• Exports increase (lower prices)

Question 12

What policies are used to tackle demand-pull inflation?

Answer 12

Decrease aggregate demand:
- Contractionary fiscal policy (raise taxes, reduce government spending)
- Contractionary monetary policy (raise interest rates, reduce quantitative easing, appreciate exchange rate)

Question 13

What policies are used to tackle cost-push inflation?

Answer 13

Supply-side policies:
- Reduce regulation
- Change migration policies (allow more workers)
- Build more rails networks/airports

Question 14

What policies are used to tackle demand-side deflation?

Answer 14

Increase aggregate demand:
- Expansionary fiscal policy (lower taxes, increase government spending)
- Expansionary monetary policy (lower interest rates, increase quantitative easing, depreciate exchange rate)