Chapter 11 - Inflation

Question 1

What is inflation?

Answer 1

Inflation is defined as an economic situation where there is sustained increase in the overall level of prices or general price level in an economy.

Question 2

How is Consumer Price Index calculated?

Answer 2

• Weights are assigned to basket of goods and services commonly consumed by households, reflectin their importance.
• Weights are based on how much households spend on them
• Overall CPI is computed by combining the price indices for different items according to their weights

Question 3

How to calculate inflation rate?

Answer 3

inflation rate = (price index in year 2 - year 1)/(price index in year 1) x 100%

Question 4

What is headline inflation?

Answer 4

Headline inflation tracks the prices of goods and services generally consumed by households.

Question 5

What is core inflation?

Answer 5

Core inflation is measured by considering a basket of goods and services excluding food and energy which is volatile and have temporary fluctutations in them.

Question 6

What is mild inflation?

Answer 6

Price level rises slowly (less than 2%). Most economists feel that mild inflation stimulated economic expansion.

Question 7

What is hyperinflation?

Answer 7

Prices rise at a phenomenal rate (more than 100%). Money ceases to become a medium of exchange or a store of value and normal economic activity may break down. It is frequently associated with social instability and leads to disruptions in the economy.

Question 8

What is demand-pull inflation?

Answer 8

Demand-pull inflation occurs when general price levels increase due to a persistent increase in AD in the economy that is not matched by output of goods and services (AS).

Question 9

What is cost-push inflation?

Answer 9

Cost-push inflation occurs when general price levels rise due to rising costs of production. It is a supply-side phenomenon.

Question 10

What are the sources of cost-push inflation?

Answer 10

• Rising cost of production
  a) wage-push inflation
  b) imported inflation (rising commodity prices; depreciation)
  c) tax-push inflation (rise in indirect tax lead to rise in COP)
• depletion of natural resources and natural disasters (lower productive capacity)

Question 11

What are the effects of inflation on housesholds?

Answer 11

1. Effects on material SOL
- inflation causes purchasing power and real income/wages to fall
- fixed income earners real income fall since income is fixed
- wage earners real income will fall if inflation outpaces wage growth (except for mild demand-pull inflation)
- cost-push inflation leads to definite fall in real income
2. Effects on savings
- with inflation, more money will be needed to purchase the same amount of goods
- less proportion of income for savings
- inflation discourages savings since real value of savings fall as inflation erodes value of interest earned

Question 12

How to calculate real income/wage?

Answer 12

% change in real income/wage = % change in income/wage - inflation rate

Question 13

What is real interest rate?

Answer 13

Real interst rate is an interest rate that has been adjusted to remove the effects of inflation
real interest rate = nominal interest rate - inflation rate
Households should look at real interest rate, not nominal interest rate, when measuring rewards for savings

Question 14

What are the effects of inflation on firms?

Answer 14

Effects on production and profits:
- Mild demand-pull inflation: higher profit margins, greater investments, future rise in productive capacity, sustained economic growth
- Cost-push inflation: COP rises, lower profits/losses for firms, firms produce less or close down, investments fall (firms need to be more efficient and innovative to survive)
- High rates of inflation: associated with uncertainty, difficult to estimate their future costs and profits accurately thus effecting level of planned capital investments; higher risk of investments

Question 15

What are the effects of inflation on government?

Answer 15

Effect on govt budget balance:
- Demand-pull inflation: rising GDP and GPL leads to rising DD for labour and rising wages, increase revenues from personal income tax and indirect tax, thus improving budget balance
- Cost-push inflation: Rising prices result in increased tax revenues, but fall in GDP leads to eventual fall in DD for labour and falling wages, fall in tax revenue from personal income tax, rising expenditure on unemployment benefits, thus likely to worsen budget balance

Question 16

What are the effects of inflation on economy?

Answer 16

Impact of mild demand-pull inflation:
- higher profits, more investments, higher future productive capacity and economic growth
- higher demand for labour and employment, leading to higher consumption and AD

Impact of high inflation on AD:
- falling investments (uncertainty and risk)
- falling export revenue (higher export price)
- rising import expenditure (cheaper foreign substitutes)

Impact of high inflation on AS:
- wage-price spiral (trade unions keep asking for higher wages to offset increase in GPL)

Question 17

What are the external effects of inflation?

Answer 17

• Net export revenue falls (rising import exp, falling export revenue)
• Larger short-term capital inflows (foreigners take advantage of higher nominal interest rates due to higher inflation rate)
• Long term capital outflow due to fall in FDI (countries with high inflation are more risky, less attractive and economically unstable to foreign investors)

Question 18

What are the remedies for demand-pull inflation?

Answer 18

Contractionary demand-side policies
- Fiscal policy
- Monetary policy
- ERP Appreciation
- IPP

Question 19

How does contractionary fiscal policy address demand-pull inflation?

Answer 19

• Lower govt expenditure (on goods and services and transfer payments)
• Adjust tax rates (raise direct tax, lower import tax)
• AD falls, GPL falls

Limitations:
- Size of multiplier
- Rigidity or inflexibility of govt spending
- Time lag
- Political consideration and acceptability

Question 20

How does MP centered on interest rates address demand-pull inflation?

Answer 20

• Reduce money supply and raise interest rates
• Investments and consumption falls due to higher cost of borrowing, AD falls, GPL lower

Limitations:
- Interest elasticity of investments and consumption
- Other factors like accuracy and availability of info, size of multiplier

Question 21

How does ERP Appreciation address demand-pull inflation?

Answer 21

• Appreciation causes falling export revenue, rising import expenditure
• Net export falls, AD falls, GPL falls

Limitations:
- PED of imports
- Avalibility of foreign exchange

Question 22

How does ERP Appreciation address demand-pull inflation?

Answer 22

• Appreciation causes falling export revenue, rising import expenditure
• Net export falls, AD falls, GPL falls

Limitations:
- PED of imports
- Avalibility of foreign exchange

Question 23

How does IPP address demand-pull inflation?

Answer 23

• Lowering disposal income of households (e.g. increase employee’s CPF contribution rate)
• Voluntary and statutory restraints on wage increase
• Legislation to restrict the power of trade unions

Limitations:
- Increased borrowing
- Decrease in SOL
- Poor response to wage guidelines by firms and trade unions

Question 24

What are the policies to address cost-push inflation?

Answer 24

Short-run supply side policies:
- FP
- ERP
- IPP

Long-run supply side policies:
- Policies that raise productive capacity of economy

Question 25

What is deflation?

Answer 25

Deflation is defined as an economic situtation where there is a persitent decrease in GPL in an economy.

Question 26

What are the possible causes of deflation?

Answer 26

Possible causes of falling AD:
- Tight MP in response to inflationary pressures
- Decline in confidence

Possible causes of rising AS:
- Improvement in technology
- Falling prices of key FOP

Question 27

What are the effects of deflation?

Answer 27

• Consumers tend to benefit from deflation in the short term due to falling prices, but eventually firms face lower revenues and profits
• Rising unemployment
• Falling real income
• Deflation spiral

Question 28

What are policies to address deflation?

Answer 28

Expansionary demand-side policy