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Economic macro > Inflation > Flashcards

Inflation Flashcards

1
Q

Inflation

A

Inflation can be defined as a sustained increase in the price level over a period of time.

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2
Q

Causes of inflation

A

Demand Pull
Cost push
Wage-price spiral
Growth of the money supply

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3
Q

Demand pull inflation

A

This happens when aggregate demand rises faster than aggregate supply. Demand for goods and services rise and that pulls prices up.

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4
Q

Triggers of demand pull inflation

A
  • Depreciation in the exchange rate, causes imports to become more expensive, whilst exports become cheaper. Value of imports fall and value of exports rise. AD rises.
  • Lower taxes or more government spending.
  • High growth in UK export markets.
    PLUS OTHER AD MECHANISMS
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5
Q

Cost push inflation

A

Supply side of the economy, occurs when firms face rising costs, therefore they raise their prices.

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6
Q

Triggers of cost push inflation

A
  • Changes in the world commodity prices and affect domestic inflation, raw material may become more expensive, increased costs of production.
  • Labour becomes more expensive, wages rise, possibly because of trade unions.
  • Expectation of inflation, if consumers expect prices to rise they may ask for higher wages, this triggers more inflation.
    -Depreciation in the exchange rate means imports become more expensive and pushes up the price of raw materials.
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7
Q

Wage-price spiral

A
  • Increase in wages means consumers have more disposable income, so AD increases. Higher wages aso mean that firms face higher prodcution costs, this puts an upward pressure on the average price level in the economy. Workers then demand higher wages to keep up with inflation, which puts further upward pressure on the price level.
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8
Q

Growth of the money supply

A

If the bank of england printed more money, there would be more money flowing in the economy, extreme increases in the money supply usually result in hyperinflation, when the rate of inflation is incredibly high and uncontrollable.

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9
Q

Quantatiy theory of money

A
  • This states that there is inflation if the money supply increases at a faster rate than the national income.

MV = PQ

M refers to the supply of money
V refers to the velocity of ciruclation (money changing hands in the economy)
P is the price level
Q is the quantity of goods and services sold in the economy (REAL GDP)

MV represents total expenditure in the economy or nominal GDP.
PQ represents the total quanitiy of goods and services sold in the economy or nominal GDP

THEY HAVE TO BE EQUAL

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10
Q

Assumptions on MV=PQ

A
  • Assumption that velocity is constant as the frequency in which workers are paid is not often changed, consumers and firms wont signficantly alter the rate they buy goods in the economy.
  • T or Q, Real GDP or the trend rate of growth has minor deviations in booms and recessions, but it doesnt deviate enough to influence prices.
  • Increasing the supply of money increases inflation. When the money supply increases, consumers spend more, AD shifts to the right and firms increase supply in the short run, positive output gap occurs which is infaltionary.
  • Wages also increase as a result, therefore costs for firms rise and they raise prices.
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11
Q

Keyensians disagree with MV=PT

A
  • V can decrease signifcantly in a recession for example.
  • Money supply may increase in a recession, but a liquidity trap may mean that money supply is being saved by not resulting in a increase in a inflation rate.

SO in a recession it doesnt hold

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12
Q

Solutions

A
  • Reduce expectations
  • price controls
  • Wage control
  • Supply side policies
  • Lowering the money supply
  • Using fiscal and monetary policy in order to control AD.
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13
Q

Reducing expectations

A
  • Inflation expectations is a key determinant of inflation.
  • If people expect inflation workers will demand higher wages and firms will raise prices.
  • The central bank and governemnt can make credible commitments to keeping inflation low, this will help.
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14
Q

Price controls

A
  • Firms increasing prices to maintain profability and deal with rsing costs is a cause of inflation.
  • The government could set limits on price increases for firms.

ALTHOUGH
- Firms may end up reducing supply.
- May hurt economic growth and certain industries

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15
Q

Wage control

A

Limiting wage growth will reduce costs for firms and keep prices down.

  • Only works with cost-push inflation
  • If trade unions are powerful this can be very difficult and involves cooperation from across the economy.
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16
Q

Controling the money supply

A
  • Monetarists believe there is a strong link between money supply and inflation, if you can control the growth of money supply then you should be able to bring inflation under control.
  • Link between money supply and inflation is less strong and there are more important policies such as monetary and fiscal.
17
Q

Supply side policies

A
  • Rising costs and uncompetiveness. Increase productivity and the supply of labour may decrease inflationary pressures

BUT
- Long time lag

18
Q

Costs for consumers

A
  • The real value of savings will fall when adjusted for inflation.
  • Purchasing power on those with low and fixed incomes will fall.
  • The real value of debt falls, this benefits people on high levels of debt.
19
Q

Costs for firms

A
  • Loss of international export price competitiveness
  • Increased uncertainty EVAL investment may infact rise as firms may ‘piggy pag’ inflation for more profits.
  • FDI may fall, why buy into a economy where tha value of money is falling?
  • Menu costs are greater, for example chaging price lists, when inflation is high prices need to be frequently changed.
  • Wage differentials can be changed without cutting nominal wage
20
Q

Costs for governments

A
  • The government will have to spend more money on those on low fixed incomes, higher benefit payments, government deficit, maybe even debt?
    EVAL the governments borrowing becomes cheaper to pay back because the real interest rate has fallen.
    EVAL More borrowing could cause crowding out and therefore a fall in AD and reduction in inflation?
  • Fall in exports and a deterioation in the UK current account. This could be offset with a depreciation in the currency, ONLY IF they have a floating exchange rate.
21
Q

Costs for workers

A
  • Workers on low and fixed incomes will likely suffer.
  • Some firms may be more reluctant to invest in all factors of production, job oppurtunities may fall.
  • SOME workers that are part of strong unions may see wage rises.
22
Q

Other costs - Uncertainty

A
  • Uncertainty, people are more uncertain about what to spend there money on and firms are less willing to invest, uncertaiinty over future prices and profits. This can lead to lower rates of long run growth.
23
Q

Costs of inflation - Income redistribution

A

Inflation will typically make borrowers better off and lenders worse off. Inflation reduces the value of savings, especially if the savings are in the form of cash or bank account with a very low-interest rate. Inflation tends to hit older people more. Often retired people rely on the interest from savings. High inflation can reduce the real value of their saving and real incomes.

24
Q

Costs of inflation - Costs of reducing inflation

A

High inflation is deemed unacceptable therefore governments / Central Bank feel it is best to reduce it. This will involve higher interest rates to reduce spending and investment. This reduction in Aggregate Demand (AD) will lead to a decline in economic growth and unemployment. Inflation is reduced, but there is a cost to other macro-economic objectives. Therefore, it is better to keep inflation low and avoid later more costly efforts to reduce it.

25
Q

EVAL of inflation - Fiscal drag

A

Fiscal drag is a concept where inflation and earnings growth may push more taxpayers into higher tax brackets. Therefore fiscal drag has the effect of raising government tax revenue without explicitly raising tax rates.This is because with rising wages more people will slip into the top income tax brackets.

This fiscal drag has the effect of reducing (or limiting increase) in Aggregate Demand and becomes an example of a mild deflationary fiscal policy. It could also be viewed as an automatic fiscal stabiliser because higher earnings growth will lead to higher tax and therefore moderate inflationary pressure in the economy.

26
Q

Deflation

A

A fall in the general price level, negative inflation, when the inflation rate is below 0.

For example -1%

27
Q

Why does deflation occur relatively infrequently

A

Infrequently falling wages, thus making it difficult for firms to lower prices, also their is a general avoidance for firms to lower prices as this cuts into their profits.

28
Q

Causes of delfaltion

A
  1. Fall in AD, recession, fiscal austerity, decline in confidence, fall in the money supply, higher interest rates.
  2. Lower costs, fall in SRAS, lower costs of production, for example due to lower oil prices and improved technology.
29
Q

Deflationary spiral

A
  • Falling prices in the economy may mean that firms want to cut wages, lower wages lead to less spending and lower costs. Falling prices lead to a decline in confidence and therefore there is lower spending and investment. Deflation leads to expectations of falling prices and therefore people wont spend unless prices fall, they delay spending until they do.
30
Q

Consequences of deflation - Cyclical unemployment

A

As the price level falls consumers and firms will avoid spending, this causes prices to fall further as AD continues to fall. This may result in a DEFLATIONARY spiral. Price level falls, spending is postponed, AD fallls, price level falls, spending is postponed, AD falls.
This process results in deeping recession, negative output gap and high levels of cyclical unemployment.

31
Q

Consequences of delfation - Increases the real value of debt

A

Deflation increases the real value of money and the real value of dept, deflation makes it more difficult for debtors to pay of their debtors. This can lead to more bankrupcy and if this is widepsread than the banks will suffer losses on their loans, increasing the risk of financial crisis.

Furthermore consumers and firms will spend more of their income on debt repayments and less on consumption and investment, AD and prices continues to fall.

32
Q

Consequences of deflation - increased real interest rate

A

Interest rates cannot fall below 0, if there is delfation of 2%, this means the real interest rate is 2%. Therefore deflation can contribute to unwanted tightening of monetary policy.

33
Q

Consequences of deflation - real wage unemployment

A

Labour markets often exhibit ‘sticky wages’. In particular, workers resist nominal wage cuts (no one likes to see their wages actually cut, especially when you are used to annual pay increases. Therefore, in periods of deflation, real wages rise. This could cause real-wage unemployment.

Real wage unemployment occurs when wages are set above the equilibrium level causing the supply of labour to be greater than demand.

34
Q

Consequences of deflation - it can become entrenched

A

Deflation can become entrenched and difficult to end, particulary when we enter a deflationary spiral and continuously falling prices.

35
Q

Advantages of deflation

A
  • Increased international competitiveness, if one country has deflation and the other inflation, than that country will be more internationally price competitive, leading to a rise in exports.
  • Deflation from increased efficiency and lower costs of production, the right kind of deflation involves lower prices through increased prodcutivity and better technology.
36
Q

Types of deflation

A
  • Deflation may becaused by a fall in AD or a increase in SRAS, we can regard a fall in AD as ‘bad’ deflation. However no deflation will always bee good and can result in a banking crisis and a deflationary spiral.
    All deflation is DANGEROUS.

Economic macro (15 decks)

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