Chapter 6-3: Inflation and Deflation

Question 1

Define Inflation and Deflation

Answer 1

Inflation is the sustained increase in the general price level of an economy over time. Deflation, i.e. negative inflation, is a sustained decrease in the general price level of an economy over time.

Question 2

Define Price Stability

Answer 2

Price stability means that the general price level in an economy increases at a low, stable and expected rate. There is an absence of high inflation and deflation.

Question 3

Low vs deflation

Answer 3

• Low inflation basically means inflation that is benign, i.e. harmless and is under control. There is no fear of inflation spiralling out of control. In fact, it is an indication that the economy is experiencing healthy economic growth. Today, most countries have set an inflationary target of 2% in order to ensure price stability. However, there is no standard or universally accepted figure.
• On the other hand, deflation or negative inflation rate is undesirable because it is often associated with demand deficiency and negative or very slow/sluggish growth in the economy.

Note: But deflation as a result of a faster rise in the productive capacity of the economy may be deemed as beneficial.

Question 4

Measuring Inflation and Deflation

Answer 4

• Inflation is measured by tracking the rise in the general price level over time.
• A price index is used to measure changes in general price level over time.
• The most common price index used is the CPI or Consumer Price Index, sometimes referred to as Retail Price Index.

Question 5

Consumer Price Index

Answer 5

Consumer Price Index
The CPI measures the average level of prices of a basket of goods and services consumed by a typical household.

• A CPI is made up of 3 key elements:
  
  • Basket of goods and services - to represent the consumption pattern of a typical household
  • Base year - a chosen year used as a reference point for comparing prices over time. It is typically an average year where prices are relatively stable. The price index for the base year is always 100.
  • Weights - to take into consideration the relative importance of each item in the basket of goods bought by a typical household. This is measured by the % of total expenditure spent on each item. Those items that take up a greater % of total household expenditure will have a higher weight relative to those which the household spends less on

Avg price index for base year = Total Weighted Price Index / Total Weights.

Question 6

Uses of CPI

Answer 6

Measure of Inflation

• The index is widely used by a government to provide information about the rate of inflation (or deflation) in the economy. This enables the government to implement appropriate remedial policies.
• The inflation rate is a measure of the rate of change or % change in general price level over time.

COL

• This refers to the expenditure or the amount that consumers need to spend to reach a certain utility level or standard of living. Whilst the CPI does not directly measure cost of living, both concepts are inter-related.
• Changes in the cost of living can be monitored by comparing the CPI of the different years. For example, if the CPI increases, it means a fall in purchasing power of money, hence more expenditure is required to buy the same bundle of goods and services thus leading to an increase in the cost of living.

Wage Adjustment
The CPI is of interest to trade unions since an increase in the cost of living provides a basis for an increase in wages. In practice, trade unions often press for cost of living adjustments or allowances
when negotiating higher wages for their members. This is to ensure real wages of workers are protected from the corrosive effect of inflation on purchasing power of money or nominal income.

Question 7

Limitations of CPI

Answer 7

• The more an individual household’s consumption pattern diverges from that of a typical household, the less effective the price index would be. One way to overcome the problem of over-generalisation, is to calculate specific indices for different types of households. E.g. the upper income group and the lower income group or for the different races or even for expatriates.
• For example, Singapore was ranked as the fourth most expensive city out for expatriates in contrast to only 48th for locals in a research done by Lee Kuan Yew School of Public Policy.
• The CPI is more useful in making comparisons over relatively short periods of time. As a country develops in the long-run, expenditure patterns are likely to change. Thus, comparing a CPI that is based on a representative basket of goods A in 1970 and one that is calculated 20 years later
  based on a different basket of goods B may not be meaningful. In practice, the base year and items to be included in the basket of goods in the computation of CPI have to be periodically updated to reflect the changing consumption patterns of the target group under study.
• Changes in the quality of the goods and services that are included in the basket tend to go unrecorded in the construction of the CPI. In other words, the improvement of the goods and services and hence standard of living are not taken into account when calculating CIP and price level increases.

Question 8

Calculation of Inflation rate

Answer 8

The CPI is used to measure the rate of inflation in the economy using the following formula:
Rate of Inflation = [ CPI for period (2)-CPI for period (1)/ CPI for period (1) ] x 100

The inflation rate could be negative when the general price level falls. This situation is referred to as deflation. A good example of a country which experienced deflation in the 1990s is Japan when general price level fell over a prolonged period.

Generally, a rise in inflation means a faster increase in price levels whereas a fall in inflation means a slower increase in price levels.
Note: Price level is still increasing as long as inflation rate is positive.

Question 9

Different Degrees of Inflation

Answer 9

The rate of inflation as measured by the CPI can be used to indicate the severity or degree of inflation. In reality, the degree of inflation can range from very high/severe to low or mild.

Mild
Creeping or moderate
Hyperinflation
Disinflation

Question 10

Mild Inflation

Answer 10

• It is characterised by a slow rise in annual price level of 2% or below. Most economists feel that a low rate of changes in price levels might stimulate economic expansion. This has beneficial effects on the economy as it is a sign of a buoyant economy or an expanding economy with output and employment growth.
• Central banks such as the Bank of England adopt inflation targetS of 2% or below as the basis for conducting its monetary policy.

Question 11

Creeping or moderate Inflation

Answer 11

It is a more substantial and persistent annual increase of 6% to 7% in the general price level.

Question 12

Hyperinflation, Galloping Inflation, Runaway Inflation

Answer 12

• This is a situation where prices rise at a phenomenal or alarming rate. It is a sign that inflation has gone out of control. Prices are rising so fast that money ceases to be a medium of exchange and a store of value.
• Normal economic activities may even break down. In this case, the general price level can rise by more than 100%.
• During hyperinflation, people understandably do not want to hold on to any domestic currency. The value of money has diminished to the point where it has become worthless paper currency, where everything including basic items like food and shoes cost millions,
  billions or even zillions of dollars. In fact, the severity of hyperinflation is determined by how long it takes for prices to double.
• Workers insist on getting paid at least daily so that they can immediately buy things before any price increase or before exchanging local currency for a more stable currency, such as
  the U.S. dollar. As a result of hyperinflation, everyone, including merchants, will have difficulty in keeping up with rising prices.
• Hyperinflation is usually associated with social instability and disruption to the economy arising from war or crisis. Zimbabwe has so far the highest recorded inflation in the 21st century and the top “honour” goes to Hungary after World War II. Currently, Venezuela takes the top spot with 80,000% inflation in 2018.

Question 13

Disinflation

Answer 13

• This is a situation when price levels are still rising but at a decreasing rate, i.e. inflation rate is falling over time but it remains positive.
• Note: Do not confuse disinflation with deflation. Deflation is a sustained in general price level, hence the inflation rate is recorded as negative. It is usually prolonged and is associated with economic depression or recession.

Question 14

Core and Headline Inflation

Answer 14

• Headline inflation is a measure of the total inflation within an economy, including commodities such as food and energy prices, which tend to be much more volatile. These prices are considered volatile as they can rise and fall over within a short period. This may lead to knee-jerk reaction in policy-making.
• On the other hand, core inflation or underlying inflation, excludes volatile food and energy prices. Volatility in prices is a bad measure of inflation since inflation is not price fluctuations or price instability but a persistent rise in price levels.
• Therefore, most countries distinguish core inflation from headline inflation to aid them in policy-making decisions.

Question 15

Benign vs harmful inflation

Answer 15

It is important to note that inflation is not always undesirable. Inflation is harmful or undesirable if it is high, severe and unstable. The worst-case scenario is that of hyperinflation, which could cripple or impoverish an economy.

The ideal is to achieve a low and stable rate of inflation or price stability for an economy.

If inflation is low and stable, it is benign or harmless. A low and stable rate of inflation is usually predictable and therefore households and firms can take precautionary measures to protect themselves from its potential harmful effects e.g. nominal wages can be adjusted to ensure inflation does not erode its purchasing power or nominal interest rates can be adjusted to ensure the purchasing power of savings is protected.

Low and stable inflation makes it easier for firms to predict future earnings and costs, and thus avoid the risk of too much uncertainties in making investment decisions.

Question 16

Costs (4) of High Inflation - Consumer

Answer 16

(There’s too much to elaborate on wow)

Erodes Internal Value of Money or Purchasing Power of Money
Discourages Savings and Increases Consumption
Impact on Income Distribution
Shoe-leather costs

Question 17

Costs (2) of High Inflation - Producer

Answer 17

Discourage Investment
Severe price instability discourages investment because it makes it difficult for firms to predict future sales revenue and costs, hence the expected future returns from investment. In such an unstable and uncertain environment, investment is too risky for firms to undertake.
Hence, firms may delay or cut back investments. For instance, firms may decide not to build more plants, factories, offices, hotels, shopping malls etc.

Menu Cost
There is also menu-costs which are incurred by firms when there is a constant need to update price lists in restaurant menus, catalogues, price tags, bar codes and advertisements to keep pace with rising prices. This would result in higher expenses in re-printing price tags.

Question 18

Cost of High Inflation - Government - Hinders Economic Growth and Employment

Answer 18

Hinders Economic Growth and Employment
- Severe inflation may stifle or hinder economic growth and worsen unemployment as it discourages both saving and investment which are fundamental to promote long term economic growth.
- In the case of cost-push inflation, the economy suffers from a concurrent rise in GPL as well as a contraction in output or a recession. The underlying causes could be due to wage cost
pressures, high import cost or supply shocks.
- This phenomenon is sometimes called stagflation. In such instances there is negative growth as output contracts and there is unemployment.

Question 19

Costs of High Inflation - Government - Worsens the Balance of Trade, Capital flight and Lowers Value of Exchange Rate (Details on the Balance of Trade can be found in Chapter 6 Part 4)

Answer 19

(Technical difficulties but rmb the explanations)

Dampen Export Earnings (X)
Increases Import Expenditure
Impact on BOT = X - M
Capital Flight
Impact on Exchange Rate

Question 20

Anticipated vs Unanticipated Inflation

Answer 20

• Anticipated Inflation
  
  • Anticipated inflation is when the rise in general price level is as predicted or close to the one expected. If firms, workers, consumers and the government have correctly predicted the inflation rate, they will be more prepared in taking measure to avoid the harmful effects.
  • For example, firms can adjust their prices to reduce erosion of profit, financial institutions can increase their nominal interest rate to maintain real interest rate, consumers may be able to distinguish between changes in the general price level and relative prices and government can adjust tax thresholds and index-linked
    pensions, benefits and civil servants’ pay in line with anticipated inflation.
• Unanticipated Inflation
  
  • Unanticipated inflation occurs when inflation is either not anticipated or is higher than expected. This will cause a number of problems. As people and firms have been caught unaware, the uncertainties can result in a fall in consumption and investment. The consequence of unanticipated inflation will be more adverse than when the inflation is anticipated.

Question 21

Benefits of Low Inflation - Consumer

Answer 21

Preserves the value of money or internal pp of money
Consumers will benefit from low inflation as it will prevent erosion of internal purchasing power of money by maintaining real income and standard of living.
This will pre-empt pressures for cost of living adjustments when incomes cannot rise as fast as inflation, especially among the low-income households

No “unfair or inequitable” Distribution Effects
- Low inflation will not impose on fixed income earners or those living on their savings from financial hardship due to rising price level. For e.g. In the face of high inflation, low skilled, pensioners, retirees could face erosion of their purchasing power, promoting social justice and
fair play.

No High Transaction Costs i.e. little ‘shoe-leather costs’ when inflation is low.

Question 22

Benefits of Low inflation - Producers

Answer 22

• Increase investments and efficient use of resources
• Low inflation provides certainty which makes it easy for investors to make projection on costs and returns of their investments.
• There is little ‘menu costs’ when inflation is low.

Question 23

Benefits of Low inflation - Gov

Answer 23

(Go read the stuff damn it)
Promotes EG
Improves BOT and increases value of exchange rate

Question 24

Benign vs Harmful Deflation

Answer 24

Deflation is harmful when:
- AD falls (economy moving away from the full employment output), signalling falling output and rising unemployment, which is usually accompanied by a recession.
- It becomes entrenched or prolonged when falling prices becomes a “spiral of death” with no end in sight. This happens if consumers hold back spending in anticipation of further falls in prices, causing a vicious cycle of falling prices and falling expenditures to become entrenched. In such
instances, the economy can plunge into a deep recession or depression.

Deflation is benign when:
AS rises (expansion in the economy's productive capacity or due to fall in major commodity prices like crude oil). In such instances, the economy moves closer towards the full employment level of output. In fact, more is produced at lower prices. There is no imminent danger of sliding into a recession.
It is no prolonged

Question 25

Cost of Harmful Deflation - Postponing C and I

Answer 25

In an environment where deflation is the norm, consumers stand to gain if they postpone their consumption or purchases in anticipate of failing or cheaper prices.
If every consumer postpones consumption, businesses will suffer major losses in sales. Thus, there will be no incentive for businesses to carry out investment to sustain production.
Moreover, as prices falls, businesses are faced with the real prospect of ending up with losses because their cost (based on earlier purchases of inputs) is likely to be higher than sales revenue.
This process of delayed consumption leading to business losses can become entrenched to the point that there is widespread business closure/failure.
All these reduce overall economic activity and can lead to a so-called ‘deflationary spiral’, plunging the economy into a deep recession with high levels of unemployment and low incomes.

Question 26

Cost of Harmful Deflation - Increase Unemployment and fall in Standard of Living

Answer 26

• Deflation will bring about falling revenues for firms but workers will resist cuts in their nominal wages. As such, unless workers’ productivity improves to lower unit cost of production, employers will have no choice but to retrench workers to maintain their profitability since the revenues
  generated will be insufficient to cover costs.
• The loss of incomes of these workers will adversely affect their material standard of living.

Question 27

Demand-Pull Inflation

Answer 27

Demand-pull inflation arises when there is excessive aggregate demand in an economy that outpaces aggregate supply, hence leading to a rise in general price levels with little or no increase in real output

Question 28

Cause and Analysis of D-Pull Inflation

Answer 28

Demand pull inflation is due to 2 major causes:

- Excessive spending (linked to optimism in a booming economy)
- Excessive Money Supply (linked to cheap and easy credit)

This is a type of inflation arising from a rise in AD (shift AD to the right) with no or little increase in the productive capacity of the economy, i.e. the firms are facing a supply bottleneck or tight capacity - close to the full employment output. The increase in AD leads to competition for factors of production and hence driving up costs (GPL), reflected as a movement along the AS curve.
Optimism in a booming economy: This rapid rise in AD due to investment (e.g. oil discovery) or export boom may lead to excessive spending or splurging on consumption which is reinforced by the psychological “feel good” factor. In a booming economy, there is general unrestrained consumption or euphoria as the urge is to spend freely on the assumption that the good times will never end.
Cheap Credit: Alternatively, the rapid rise in AD could be fuelled by the availability of cheap and easy credit. Banks are willing to lend on liberal terms (e.g. promotion of credit cards), and at low interest rates which encourages consumers to spend freely or splurge e.g. buy cars, homes
on credit and go shopping spree with their credit cards.

Question 29

Graph Analysis of D-pull Inflation

Answer 29

• In order to meet the rising demand, firms will increase their production as long as the prices of their goods are rising faster than the prices of inputs they use in production.
• To do that, they will need to acquire more resources (factors of production) which will be in competition with other users for these resources, e.g. drawing workers from other industries, employ less skilled workers, encourage workers to work overtime, extend the hours of part-time workers, hire recently retired workers,
• Thus, there is an increase in unit cost of production (as shown by the movement along the upward sloping portion of AS).
• Eventually, price level rises from P0 to P1 as the economy reaches full capacity (operating at its potential) and output cannot increase further.

Question 30

Cost-push Inflation

Answer 30

Cost-push inflation arises when the short-run aggregate supply in an economy falls due to persistent increase in costs of production, for reasons not associated with increase in aggregate demand, hence leading to a rise in general price level.
A significant increase in oil prices would affect the economy through higher costs of production. In order to protect their profit margins, businesses have to raise the price of their output by the increase in their unit cost. This explains why the SRAS shifts left as cost of production rises.

Question 31

Types of Cost-Push Inflation

Answer 31

Just… go read

Imported Inflation
- Rising P of key imports
- Weak currency
Wage-Push Inflation
Profit-Push Inflation
Negative Supply Shocks
Statutory-cost push inflation
- Rise in indirect taxes on G&S
- Implementation of COE for Vehicles, ERP (SG)

Question 32

Wage - Price Spiral

Answer 32

• If inflation expectations (i.e. expectation of higher prices in the future) could drive workers to demand higher wages rates, and if workers (through the help of trade unions) are successful at securing higher wage rates though there is no improvement in productivity, unit costs of production will rise. This will cause the AS curve to shift to the left from SRAS0 to SRAS1.
• Firms respond to the rising costs of production by cutting back on the workers they hire. To prevent a rise in unemployment, the government boosts the level of aggregate demand by increased spending on infrastructure and/or by cutting taxes. This shifts the aggregate demand curve to the right from to AD1.
• The net effect on output and employment may be very small or even fall, but price levels may rise considerably, If there are substantial shifts in AS and AD, a wage-price spiral will result. Trade unions will demand higher wages. To offset rising cost of living, firms increase their prices to cover rising costs of production. Wages and prices further increase, contributing to a wage-price spiral.

Question 33

Dealing with Inflation

Answer 33

• Since inflation is multi-causal, one should adopt a multi-pronged approach to solve it. This means that the “cure” for inflation may involve a combination of policies that include both demand management and supply side policies.
• During periods of severe (i.e. galloping) inflation, the consequences of inflation could be dire. It could trigger a wage-price spiral, where inflation feeds further inflation. Even worse, inflation, if left unchecked, could erode the functions of money and may eventually lead to monetary and economic collapse. Thus even if inflation is caused initially by shifts in SRAS to the left, the short term repercussions need to be dealt with using contractionary demand management policies to mitigate inflationary pressures.

Unintended Consequences
However, there is a downside to dampening demand to slow down
price increases brought about by rising costs - it will worsen the contraction in output, thus leading to even higher levels of unemployment. In Figure 4, if both AS and AD curves are shifted leftwards simultaneously, the contraction in output will be amplified.

Question 34

Reversing harmful Deflationary Pressures

Answer 34

Challenge in reversing harmful deflationary pressures
To reverse the trend of falling prices or deflationary spiral, it is often not enough just to adopt stimulus measures such as monetary and fiscal stimulus without changing price expectations.

The key is to get people to start spending and not postpone consumption. That in theory can be done by changing inflation expectations.

Countries fighting deflationary pressures like Japan for instance have set inflation targets (2% and above) to stimulate spending in the economy. By deliberately creating inflation, the argument is consumers will start to spend, and not postpone consumption, as purchasing power of their income starts to shrink.