7.5 Inflation and the Phillips curve

Question 1

What’s the difference between disinflation and deflation?

Answer 1

deflation: prices are falling
disinflation: prices are rising at a slower rate

Question 2

What is demand pull inflation?

Answer 2

sustained rise in the price level caused by an increase in aggregate demand

Question 3

What is cost push inflation?

Answer 3

sustained price in the price level causes by a reduction of SRAS

Question 4

What is fisher’s equation of exchange?

Answer 4

MV = PQ

M = Money Supply
V = Velocity of Circulation of Money
P = General Price Level
Q = Output produced in an economy

Question 5

What is assumed about fisher’s equation?

Answer 5

V and Q are stable

This means changes to the money supply directly impact price level

Question 6

What are the consequences of inflation?

Answer 6

Wage-price spirals
Shoe leather costs
Menu costs
International competitiveness
Investment
Income redistribution
Fixed incomes
Savings

Question 7

What are higher wage spirals and how are they a consequence of inflation?

Answer 7

Higher inflation will increase wage demands from workers to maintain real incomes, which may cause yet further inflationary pressure. It may also place additional strain on industrial relations and pay bargaining

Question 8

What are shoe leather costs and how are they a consequence of inflation?

Answer 8

A lack of certainty over price levels increases the search costs, predominantly time, of making price comparisons in looking for the best deal

Question 9

What are menu costs and how are they a consequence of inflation?

Answer 9

The costs to a firm of changing pricing information on e.g. labelling, bar codes, advertising

Question 10

How does inflation impact international competitiveness?

Answer 10

If inflation is higher than our main international competitors, this is likely to damage our ability to export

Question 11

How does inflation impact investment?

Answer 11

Given that inflation erodes the value of money over time, inflation will similarly erode the value of investments in the future.

Question 12

How does inflation impact fixed incomes?

Answer 12

For those on fixed incomes e.g. pensioners, inflation represents a fall in real incomes. It is important for these groups that benefits are correctly index-linked

Question 13

How does inflation impact savings?

Answer 13

The real value of savings is eroded if interest rates on savings are lower than the inflation rate, which reduces the incentive to save, Conversely however, the real value of debt will fall

Question 14

How does inflation cause high income redistribution?

Answer 14

Overall, high inflation can have a regressive effect on low and/or fixed income families who suffer more proportionately the higher burden of rising energy or food prices

Question 15

What are the two types of deflation?

Answer 15

Benign (good) deflation

Malevolent/malign (bad) deflation

Question 16

What is benign deflation?

Answer 16

Caused by increase in AS, which leads to a lower price level and higher GDP - typically caused by falls in commodity prices or technological advances, decreasing costs of production

Question 17

What is Malevolent/malign (bad) deflation?

Answer 17

Caused by falling AD leads to falling prices and also falling real GDP (cyclical) - causes a downward multiplier effect

Question 18

What are the consequences of deflation?

Answer 18

Delayed purchases and consumer spending
Wages and Unemployment
Debts
Confidence
International Competitiveness
Real Interest Rates
Entrenchment

Question 19

How can other economies affect inflation in the UK?

Answer 19

Growth in foreign economies will increase the demand for UK exports - could lead to demand pull inflation
Recessions in trading partners will ease demand pull pressure due to reduced spending
Growth or increased growth will lead to more demand for commodities and other basic production materials, causing cost push inflation
Changes in the exchange rate will also cause cost push inflation as imports rise

Question 20

What does phillips work suggest?

Answer 20

That changes in unemployment have direct and, to some degree, predictable effects on inflation

Question 21

How do you summarise the phillips curve in terms of:
Unemployment
Wage rates
Inflation

Answer 21

• When unemployment is low, wages must be high due to workers being a scarce resource
• This gives them more bargaining power
• Therefore inflation will be high
• This was derived from the AD curve

Question 22

How do you draw the long run phillips curve model?

Answer 22

1. Demand side shock and AD shifts right (unemployment falls in the SR)
2. Due to falling unemployment, workers will demand higher wages moving SRAS left (Taking the economy back to YFE at a higher PL)
3. This with shift the SRPC right taking it back to the original rate of unemployment
4. This then sets the position of the LRPC which is at the NRU and NAIRU and is a LR equilibrium point

Question 23

What is NRU?

Answer 23

Natural rate of unemployment

Question 24

What is NAIRU?

Answer 24

Non accelerating inflation rate of unemployment