CH10 Inflation Flashcards
What is the impact of rising AD on inflation?
When AD rises along the intermediate range, a shortage occurs in the economy at the initial GPL. As the economy reaches full employment, resources become increasingly limited. In order to increase their production and meet the rising AD, firms compete for these scare resources by offering a higher price. As each additional unit of output becomes costlier to produce, firms will raises prices for their goods and services so that production remains profitable.
Hence, an increase in RNY is accompanied by an increase in the GPL.
If AD continues to rise to AD2 in the classical range of AS, all resources are already fully utilised. Rise in AD along the classical range will not result in a higher RNY but only an escalation of prices.
What is wage-push inflation?
Wages are one of the most important components of a firm’s costs. Wage increases have an important effect on prices. Powerful trade unions may have the ability to coerce firms to increase wages without corresponding increases in labour productivity. The rise in wages leads to a rise in the cost of production. It would lead to an upward shift in the AS curve, leading to rising GPL.
How does rising commodity prices lead to imported inflation?
The extent to which domestic inflation is affected by imported inflation depends on the quantity and nature of the imports consumed.
e.g 1973-1974, when OPEC countries quadrupled the oil prices, which resulted in many oil importing countries experiencing higher costs of production.
Electricity runs on fossil fuels like oil, hgihger oil prices raise the cost of generating electricity. This results in higher prices of electricity. Higher electricity price raises the cost of producing goods.
Oil is used to produce petroleum products like oil.
How does the depreciation of the domestic currency lead to imported inflation?
Depreciation of the domestic currency results in imports being more expensive. This would include imported raw materials and food. This leads to an upward shift in the AS curve, leading to rising GPL.
What is tax-push inflation?
An increase in indirect taxation leads to rising GPL. Producers view the rise in indirect taxes as a rise in cost of production. With higher indirect taxes, supply of goods and services falls. This would lead to an upward shift in the AS curve.
How does a rising cost of production impact inflation?
Firms facing a rise in costs would respond by cutting back on production. Thus, an increase in the cost-of-prodtn causes the aggregate supply curve to shift upwards. At current price P0, there is a shortage of goods and services. Shortages drive prices up from P0 to P2.
How does the depletion of natural resources and natural disasters lead to cost-push inflation?
CPI may be due to the consistent depletion of natural resources. It occurs when the renewable resources and non-renewable resources become scarce because they are consumed faster than they can recover.
The lack of availability of such resources will reduce the potential output of an economy. With lesser factors of production, AS curve shifts leftward from AS0 to AS1, as shown in figure 4.
A fall in productive capacity due to the reduction in the availability of resources would also lead to a rise in the cost of production.
In the event there is a major natural disaster, resources would be destroyed and there would be less resources available. This would lower the supply of labour, cetpar, causing a rise in the wages. This AS curve would then shift upwards due to the rising cost of production as well as leftwards due to the falling productive capacity.
What are the consequences of inflation on households?
Material SOL measures the quantity of goods and services accruing to each person in the country. Inflation, regardless of demand-pull or cost-push leads to a higher cost of living. Real income measures the purchasing power of income, adjusted for inflation. Purchasing power of income is its ability to buy goods and services.
%Δ Real Income = %Δ Nominal Income - Inflation rate
With higher prices, purchasing power of income falls, households are now able to purchase lesser goods, assuming their nominal income remains constant.
Fixed income earners like retirees are often greatly affected by inflation because many of them live off fixed incomes like pensions. A rise in prices would mean that they will not be able to consume the same amount of G&S.
In the case of cost-push inflation, the fall in AS leads to a rise in price as well as fall in output. The fall in output would lead to a fall in demand for labour and hence a fall in wages. In this case real wage would surely fall since nominal wages are falling and prices are rising.
What is the effect of inflation on savings?
With falling purchasing power of income due to inflation, more money will be needed to purchase the same amount of goods in order to maintain the same material standard of living, If a larger portion of income is used to consume goods, less is available for savings. Hence, there will be a fall in overall savings.
Inflation also discourages savings because the real value of savings is eroded as prices continued to rise. Although the reward for saving is in the interest that is earned, inflation can erode ther value of the interest earned.
Real interest rates = Nominal Interest rate - inflation rate
RIR may be negative if nominal interest rates are below the inflation rate. Hence, if households anticipate that inflation rates will be higher than nominal interest rates, they will choose to not save their money in banks. Savings decrease.
What are the effects of mild demand pull inflation inflation on firms?
- Mild Demand Pull
Producers experience higher profit margins amid rising prices since factor costs are unlikely to rise in the short term due to long term contracts between firms and suppliers. Since final product prices rise faster than cost of FOP, greater production and investment may be encouraged due to higher expected returns. This would lead to a higher level of investment, and hence rise in future productive capavity. Thus, mild DD pull inflation generates higher employment and economic growth.
What is the effect of cost-push inflation on firms?
Cost-push inflation
In the case of CPI, cost of production rises initially, leading to lower profits or even losses for firms. Businesses that earn a lower profit may choose to either produce less or even shut down. Overall production levels may fall together with falling investments, employment and growth levels. Firms would need to become more efficient and innovative in order to survive a cost-push inflation
How does high inflation rate affect firms?
High rates of inflation, regardless of demand-pull or cost-push inflation, are often associated with uncertainty.
Firms may have difficulty estimating their future costs and thus profits more accurately. This may have an adverse effect on the level of planned capital investment and hence output of the firms.
Rising uncertainty results in higher risk in investments, which firms would only undertake if they are guaranteed higher returns.
Due to higher risks, current investments may be abandoned if their expected returns are too low to cover the increased risk.
It will hence reduce the output of firms.
