Chapter 31: Inflation and Deflation

Question 1

Inflation

Answer 1

Rise in the prices of goods and services

Question 2

Deflation

Answer 2

Fall in the prices of goods and services

Question 3

Disinflation

Answer 3

Fall in the rate of inflation

Question 4

Disinflation

Answer 4

Fall in the rate of inflation

Question 5

Cost push inflation

Answer 5

• Occurs when the price level is pushed up by increases in costs of production
• Firms will usually raise their prices to maintain profit margins
• Wages may increase from more productive labour
• Initial rise in the price level is likely to cause workers to press for even higher wages leading to a wage price spiral
• Increase in cost of raw materials
• Increase in indirect taxes
• Higher cost of capital goods and increases in profit margins
• Supply curve shifts left and forces price up

Question 6

Demand pull inflation

Answer 6

• Price level is pulled up by an excess demand
• Higher consumption, higher investment, higher government expenditure, or higher net exports - increases demand
• Increase in demand does not cause inflation if aggregate supply can extent to match it
• If exonomy is experiencing shortage of some resources, then inflation occurs
• Demand created by excessive growth of the money supply - monetary inflation

Question 7

Consequences of inflation

Answer 7

Harmful:
- Fall in the value of money
- Inflation redistributes income in an unplanned way
- Existence of inflation imposes extra costs on firms
- Creates uncertainty
- Harm the country’s balance of payments
- Cause fiscal drag

Benefits:
- Most likley to occur if the inflation is demand pull, low and stable nature and below rival countries
- May encourage firms to expand
- Reduces real burden of any debt
- Prevent some owkres being made redundant - workers may accept their wages rising by less than inflation

Question 8

Policies to control inflation

Answer 8

• Setting by a government of an inflation rate target
• Contractionary policies to decrease demand pull inflation
• People may react in a way that turns demand pull inflation to cost push inflation
• Workers may respond to higher income rates by demanding higher wages or may opt out of the labour force
• Could cause unemployment
• To reduce cost push inflation, government will use supply side policy which may be costly and add to aggregate demand

Question 9

Causes of deflation

Answer 9

• Result from supply side or demand side of the economy
• PRice level may be reduced as a result of advances in technology and increases in labour productivity
• Consumers can enjoy more goods and services
• Economy may become more internationally comeptitive
• Deflation resulting from decline in demand is harmful
• Can lead to a downward spiral in economic activity
• Consumers expecting prices to be lower
• Firms likley to reduce their output and the numberof workers they employ
• Reduction in employment will push down demand futher

Question 10

Consequences of deflation

Answer 10

• Good deflation may reduce a current account deficit or increase a current acount surplus if demand for exports and imports is elastic and if the fall in the pric elevl is not offset by a rise in the exchange rate
• Good deflation increases output and employment
• Bad deflation is likely to cause a rise in unemployment and lower output
• Likely to discourage investment which will reduce productive capacity and endanger future growth
• Both bad and good deflation increase the purchasing power of those whos incomes remains unchanged
• Raises the burden of debt
• Borrowers will gain

Question 11

Policies to control deflation

Answer 11

• Expansionary policy
• Inflation rate may be very low already and there may be little room to cut them further
• Confidence may be low and the burden of debt high so that cuts in incoem and corporation tax rates may not encourage households to spend and firms to invest