Chapter 11

Question 1

Defn. Inflation

Answer 1

an economic situation where there is a sustained increase in the overall level of prices or general price level in an economy

Question 2

Inflation rate is positive/negative meaning

Answer 2

Note: Most common measure of inflation is the annual percentage change in CPI

Positive:
- increase inflation rate means price increase faster
- decrease inflation rate (DISINFLATION) means price increase slower

Negative:
- price decrease compared to previous time period (DEFLATION)

Question 3

Headline inflation vs Core inflation

Answer 3

headline inflation:
tracks the price of goods and services generally consumed by households

core inflation:
measured by considering a basket of goods and services that excludes the price of energy and food because these are volatile and have temporary fluctuations in them

Question 4

Degrees of inflation

Answer 4

Mild inflation: price level rises slowly (usually less than 2%)

Hyperinflation/ Galloping/ Runaway inflation: prices rises so fast that money ceases to be a medium of exchange and normal economic activity may break down

Creeping inflation: between both ^

Question 5

Types of inflation

Answer 5

1. Demand-pull inflation
2. Cost-push inflation

Question 6

Defn. Demand-pull inflation

Answer 6

occurs when GPLs rise due to persistent increase in AD in the economy that are not matched by the output of goods and services (AS)

Question 7

Causes of demand-pull inflation

Answer 7

Causes are the changes in the determinants of C, I, G, (X-M)

Explanation eg.:

one possible cause of demand-pull inflation can arise from positive business expectations.
In a period where firms are optimistic about the future due to rising economic growth and falling unemployment, investments in a country may rise. (I).
Rise in investments will lead to a rise in AD.

The initial rise in AD will cause an unplanned fall in firm’s inventory. To maintain their inventory, firms need to employ more resources such as labour. As more labour are hired, they receive more in wages. The purchasing power of the labour force increases. This leads to multiple rise in induced consumption. Each subsequent rise in induced consumption will be increasingly smaller. This results in a multiple rightward shift in the AD curve, where AD is rising at a decreasing rate. The overall rise in AD from AD0 to AD1 has resulted in multiple rise in RNY from Y0 to Y1.

In fig. 2, when AD rises along the intermediate range of AS from AD0 to AD1, shortage occurs in the economy. This is because at the intermediate range, resources are becoming increasingly limited and AS is unable to meet the rise in AD. the shortages of goods and services drives up prices. thus, demand-pull inflation occurs as GPL starts to slowly rise from P0 to P1. RNY also increases from Y0 to Y1.

Question 8

Defn. Cost-push inflation

Answer 8

occurs when GPL rise due to rising costs of production (eg increase in wages, rent, interest etc.) Hence cost-push inflation is a supply-side phenomenon

Question 9

Causes of Cost-push inflation

Answer 9

1. Rising cost of production
   -> wage-push inflation
   -> imported inflation (rising commodity prices, depreciation of domestic currency)
   -> tax-push inflation
2. Falling productive capacity

Explanation:

Firms facing a rise in costs, would respond by cutting back on production. Thus, an increase in the COP causes the AS curve to shift upwards from AS0 to AS1. At the current price P0, there is a shortage of goods and services. Shortages drives up prices from P0 to P1. Thus, cost-push inflation occurs as GPL starts to rise from P0 to P1. Real NY falls from Y0 to Y1 as firms cut back on their production

Question 10

Consequences of inflation on households

Answer 10

1. Mat SOL
   -> Inflation leads to higher cost of living. With higher prices, pp of incomes/wages falls. mat sol fall
2. savings
   -> WIth falling pp pf income due to inflation, more money will be needed to purchase the same amount of goods in order to maintain the same mat so. If a larger proportion of income is used to consumer goods, less proportion of income is available for savings. Hence, there would be a fall in overall savings.
   -> Inflation also discourages savings because the real value of savings (the pp of savings) is eroded as prices continue to rise. Although the reward for savings is the interest that is earned, inflation can erode the value of the interest earned.

Question 11

Consequences of mild dd-pull inflation on firms

Answer 11

• producers may experience higher profit margins amid rising prices since factor costs (labour, energy, raw mat cost etc.) are unlikely to rise in the short term due to long term contracts between firms and suppliers of resources.
• since final product prices rises 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 future rise in productive capacity, as well as rising employment.
• thus, mild demand-pull inflation can generate higher employment and EG

Question 12

Consequences of cost-push inflation on firms

Answer 12

• COP 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. If so, 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

Question 13

Consequences of high rates inflation on firms

Answer 13

• regardless of cost-push or dd-pull inflation, high rates of inflation are associated with uncertainty.
• with rising prices, firms may have difficulty estimating their future costs and thus profits accurately. this may have adverse effects on the level of planned capital investment and hence output of firms
• rising uncertainty results in higher risk in investments. firms would undertake such high risk investments only if they are guaranteed higher returns. due to rising risk, current investments may be abandoned if their expected returns are too low to cover the increased risk. the fall in investment will hence reduce the output of the firms

Question 14

Effects of inflation

Answer 14

Internal:
1. Households
2. Firms
3. Govt
4. Economy

External:
1. Current Account (Balance of trade)
2. Capital and Financial Account
3. Balance of payments (BOP) and exchange rate

Question 15

Consequences of inflation on Current Account (Balance of trade)

Answer 15

During inflation, price of domestic goods rise thus making domestic goods to be more expensive in foreign markets. the rising export prices would then, ceteris paribus, lead to a fall in the Qd for exports. At the same time, foreign goods are now relatively cheaper in the home market compared to locally produced goods. imports are now cheaper substitutes, and ceteris paribus, the trade balance will deteriorate as net export revenue now falls. falling trade balance would worsen the current account.

Question 16

Consequences of inflation on Capital and Financial Account

Answer 16

increase in inflation rate pushes the nominal interest rates up. other things remaining unchanged, this would mean that the domestic interest rate will be higher relative to that of other countries. this may lead to foreigners wanting to transfer more funds into the country to take advantage of the relatively higher interest rates, leading to short-term capital (or hot money) inflows. Ceteris paribus, this will improve the capital account position.

however, a country with an inflation rate that is much higher than that of other countries would be seen as relatively more risky and hence less attractive and outflow due to a fall in foreign direct investment. hence the impact of inflation on the capital account is uncertain

Question 17

Remedies for demand-pull inflation

Answer 17

• Contractionary demand-side policies are used to deal with demand-pull inflation.
• (elaborate on how fiscal/monetary/ERP/IPP policy reduce AD)
• AD is lowered. GPL reduces as seen in fig.6
• the initial fall in AD will cause an unplanned rise in firm’s inventory. hence, firms will cut down on production and hence reduce demand for resources such as labour. As less labour is hired, they receive less in wages. the pp of the labour force falls. this leads to multiple fall in induced consumption. each subsequent fall in induced consumption is increasingly smaller. the results in a multiple leftward shift in the AD curve, where AD is falling at a decreasing rate. the overall fall in AD has resulted in multiple fall in RNY from Y0 to Y1.
• the fall in AD from AD0 to AD1 creates a surplus of goods and services at price P0. the surplus exerts downward pressure on prices. eventually, price falls from P0 to P1 and real GDP falls from Y0 to Y1.

Question 18

Consequences of inflation on BOP and exchange rate

Answer 18

Generally, inflation would result in the worsening of the Balance of payments (BOP). A worsening of BOP (net outflow of funds out of the country) leads to depreciation of the currency by causing a net rise in the supply of the currency. Rising supply of domestic currency leads to depreciation of the country’s exchange rate

Question 19

Remedies for cost-push inflation (short-run)

Answer 19

• SR supply-side policies are used to deal with cost-push inflation. these policies refer to any form of direct/indirect intervention into wage or price determination so as to eliminate cost-push inflationary pressures.
• (elaborate on how fiscal/ERP/ IPP policies reduce AS)
• such policies attempt to reduce cost of production without changing the productivity and efficiency of firms. Hence, AS increase and the AS curve shifts downwards from AS0 to AS1. GPL falls from P0 to P1.

Question 20

Remedies for cost-push inflation (long-run)

Answer 20

• this policy raises the productive capacity of the country by improving the productivity and efficiency of firms as well as increasing the quality and quantity of factors of production. this results in a rightward shift of the LRAS curve resulting in an increase in productive capacity of the economy. the rising AS, creates a surplus of goods and services at the current price. this surplus exerts downward pressure on price. eventually, price falls and real GDP rises.
• BASICALLY JUST REVISE CHAPTER 9

Question 21

Defn. Deflation

Answer 21

an economic situation where there is a persistent (sustained) decrease in GPL in an economy

DIFF FROM DISINFLATION

Question 22

Causes of deflation

Answer 22

1. Fall in AD
   -> the fall in AD, when the economy is operating on the upwards sloping portion of AS, would lead to surpluses of goods and services in the economy. Surplus of goods and services will drive down GPL and hence result in deflation. fall in AD will also result in a fall in real GDP
2. Rise in AS
   -> same explanation as ^

Question 23

Negative effects of deflation

Answer 23

1. Rising Unemployment
   -> during deflation, with prices falling, revenue and profits of firms would fall. some firms would end up shutting down or downsizing to cut back production. this would result in less demand for labour and hence an increase in unemployment
2. Falling real income
   -> deflation creates incentives to save and postpone spending because prices will be lower and purchasing power greater in the future. hence, deflation expectations make consumers wait for future lower prices. since C accounts for a large proportion of AD, AD decreases, slowing EG
3. Deflation spiral
   -> deflation can dampen growth and lead to a deflationary spiral. during a deflation, the falling prices trigger a chain reaction that leads to a lower production. the fall in prices, reduces firms’ revenue and profits. the fall in profits reduces the incentive for firms to produce. the fall in production leads to reduce purchasing power of households and hence leads to a decrease C. falling C leads to fall in AD. fall in AD leads to fall in both GPL and RNY that leads to further fall in production. a vicious cycle develops and this leads to further falls in GPL

Question 24

Remedies to address deflation

Answer 24

Expansionary demand policy wld be most appropriate in dealing with a deflation. fiscal, monetary, ERP, IPP

go revise chapter 9 :O

Question 25

Consequences of dd-pull inflation on govt

Answer 25

• dd-pull inflation is caused by rising AD, when the economy is operating beyond the keynesian range. this results in rising real GDP and rising GPL.
• the rising real GDP leads to higher DD for labour and hence wages. rising nominal wages and price levels could lead to increased tax revenues from personal income tax as well as indirect taxes that are levied on the price of goods and services. rising govt tax revenues improves the govt’s budget

Question 26

Consequences of cost-push inflation on govt

Answer 26

• cost-push inflation arise from a fall in AS, resulting in increased tax revenues from indirect taxes that are levied on the prices of goods and services.
• however, the fall in real GDP will eventually lead to falling demand for labour, unemployment as well as falling wages. this would lead to a fall in the tax revenue from personal income tax.
• with the rise in unemployment associated with cost-push inflation, there might be increased govt expenditure on unemployment benefits.
• overall, cost-push inflation is likely to worsen the govt’s budget due to rising expenditure and falling tax revenue

Question 27

Consequences of mild dd-pull inflation on economy

Answer 27

• producers may experience higher profit margins and rising prices since factor costs (eg. labour, energy, raw mat costs) are unlikely to rise in the short-term due to long term contracts between firms and suppliers of resources
• higher profits would stimulate more investments leading to higher DD for labour, thereby raising employment and wages. the rise in wages raises the pp and hence consumption
• the rise in C and I raises AD and hence EG. in addition, the rising investments would lead to increased productive capacity in the long-run. thus mild dd-pull stimulates greater employment and EG. this is why low inflation or price stability is a macroeconomic objective of many govts

Question 28

Consequences of high inflation on economy (AD)

Answer 28

falling investments:
- uncertainty -> firms have difficulty estimating future costs and thus profits accurately -> due to rising risk, current investments may be abandoned if their expected returns are too low to cover the increased risk -> I decrease so AD decrease -> falling real GDP and employments and productive cap in the long run

falling X:
- associated with a loss in export competitiveness. domestically produced goods become more expensive -> inflation raises export prices, leading to a fall in the Qd of exports assuming that demand for exports is price elastic , there will be a fall in X

falling C on domestically produced goods:
- foreign goods are now relatively cheaper compared to locally produced goods. domestic consumers would choose foreign goods over the higher priced domestic goods. C will fall.

the fall in I, X, C would lead to a fall in AD. lead to fall in EG and employment

Question 29

Consequences of high inflation on economy (AS)

Answer 29

regardless of the type of inflation, inflation tends to be self-perpetuating. it feeds on itself due to the wage-price spiral

• with high inflation, trade unions may demand higher wages for members to offset the rising costs of living. the higher wages raises COP for firms. production is reduced.
• AS curve will shift upwards from AS0 to AS1. Real NY increases from to. GPL increases from to.
• due to the rising prices, trade unions once again may demand higher wages to offset the rising cost of living for it members. who again (repeat on top)
• the shortage due to the falling AS also raises GPL further from P1 to P2
• this spiralling process will continue as trade unions again demand for higher wages to offset the increases in GPL. As trade unions continue to demand for higher wages, it leads to higher GPL. this is known as the wage-price spiral