Inflation

Question 1

What is the definition of inflation?

Answer 1

A sustained, inordinate and general increase in the prices of goods and services.

Question 2

How does inflation affect the value of money?

Answer 2

Inflation results in the fall in the purchasing power of money, this means that consumers can now buy fewer g/s within a given sum of money. Therefore when there is inflation, there is a decrease in the internal value of money.

Question 3

How does the CPI work?

Answer 3

It measures the change in prices of a weighted basket of g/s commonly purchased by majority of households over time. Items that form a higher proportion of household expenditure will have larger weights. i.e. Necessities / Essential g/s have a higher weightage.

!! CPI helps to identify the source of inflation !!

Question 4

What does disinflation and deflation mean?

Answer 4

disinflation refers to a decrease in the rate of inflation

deflation occurs when there is a sustianed decrease in the GPL in an economy for a sustained period of time.

Question 5

What are types of infaltion?

Answer 5

1. demand pull inflation
2. cost push inflation

Question 6

What are the causes of demand pull inflation?

Answer 6

1.Consumption: spend more, expectations of rise in income so spend more, cut in PIT, fall in i/r
2. Investment: rise in after-tax profitability, cut in CIT, fall in i/r
3. Government: higher spending
4. Net Exports: increase in NY of traiding partners (higher PPP and thus can buy more of our exports), foreigners experience higher inflation rates, domestic currency depreciates (our exports become cheaper so buy more, then buy less imports)

Question 7

What are the causes of cost-push inflation?

Answer 7

!! cost push inflation occurs when there is an increase in COP for reasons not associated with the rise in excessive demand. !!

1. Import Price Push Inflation (due to rising cost of imported goods)
   an increase in imported inputs due to inflation in foreign countries will increase unit COP causing SRAS to fall, especially in countries that rely heavily on imports.
2. Wage-Push Inflation (due to wages rising faster than productivity)
   wages are one of the most important component of firms total cost. If powerful union -> rise in wages -> rise in COP -> SRAS fall
3. Currency Depreciation
   weaker currency makes imported goods more expensive in terms of domestic currency -> higher COP -> SRAS decrease

Question 8

What are some of the demand side policies to tackle inflation?

Answer 8

1. Contractionary Fiscal Policy -> reduce G directly + rise T will reduce disposable income and limit consumption and after tax profits to fall and thus lower AD
   limitation: time lags means might affect only after the inflation is over and may be counter productive. + its also not easy for government to cut spending halfway and spark backlash
2. Contractionary Monetary Policy -> reduce money supply or increase i/r. -> higher cost of borrowing and lead to a fall in consumption and investment -> lower AD and GPL
   limitaion: in small open economies where capital can flow eaily, MP might not be effective. e.g Singapore