Inflation

Question 1

Inflation

Answer 1

Persistent rise in the general/average price level in the economy which has been sustained over a period of time.

Question 2

Price stability

Answer 2

A government objective which tries to contain the rise in the general price level to an absolute minimum. (An acceptable rate is 3% or less).

Question 3

Disinflation

Answer 3

Disinflation is when the inflation rate is falling but there is still inflation

Fall in inflation rate

Question 4

Deflation

Answer 4

Persistent fall in the general/average price level in the economy which has been sustained over a period of time.

Question 5

Hyperinflation

Answer 5

Rapid, excessive, out of control rise in price ( > 50% rise )

Question 6

Measuring Inflation

Answer 6

Price index = (cost of today’s basket / cost of basket in base year) x 100

Question 7

Measuring Inflation 2/Calculating Inflation

Answer 7

Question 8

Price index

Answer 8

An average measure of price changes for a sample of consumer goods and services, excluding producer goods and services.

Question 9

Poll 1: A fall in the inflation rate from 5% to 3% means…

A. Prices will fall
B. Prices will continue to rise
C. The value of money will be increasing
D. Those on fixed incomes will be better off.

Answer 9

B

Question 10

Poll 2: Which of the following statements is correct?

The following table shows the year on year percentage change in the price index of a country between 1990 and 1994.

A. The price level was at its lowest in 1994
B. The price level was at its lowest in 1990
C. The price level was at its highest in 1990
D. The price level fluctuated between 1990 and 1994

Answer 10

B

Question 11

Poll 3: The above table shows the annual inflation rate of a certain country. It follows that…

A. The general level of prices fell in 1996
B. The country became more internationally competitive throughout the period
C. Prices fell throughout the period
D. Prices rose throughout the period

Answer 11

D

Question 12

Calculations you need to know

Answer 12

SL: The inflation rate from a set of data using quantities purchased as weights in the CPI

HL: A weighted price index, using a set of data provided

Discuss: What are some limits of measuring inflation using CPI?

Not everyone is buying the same basket of goods and you can’t calculate every product

Question 13

Formulas

Answer 13

Question 14

Demand pull inflation

Answer 14

When too many people chasing too few goods = increase price

Demand pull inflation is usually present when the economy is close to full employment.

The economy is growing too fast.
People have too much money = want to spend more

Question 15

Causes of demand pull inflation

Answer 15

AD > economy’s production capacity = causing price rises.

Resources are fully employed and demand grows, shortages lead to inflation.

Excess AD results from increased components of AD (AD = C + I + G + (X - M)):

• Increased consumer spending (e.g., high consumer confidence).
• Increased business investment.
• Increased government spending.
• Increased export revenue (e.g., rising foreign incomes).

Question 16

Cost push inflation

Answer 16

When the cost of production increases and is passed on to the consumer by an increase in price

Things becoming expensive to make –> firms has to raise prices to make up

Question 17

Causes of cost push inflation

Answer 17

Groups within econmy use power to drive prices up –> higher costs –> raise price

Wage push inflation - workers demand for more wage –> more costs –> raise price to compensate

Import push pressures - imports is more expensive –> firms that relies on imports has to raise price to compensate

Cost push pressures - cost of FOP increase –> price increase

Question 18

Good deflation vs Bad deflation

Answer 18

Good deflation - increase in SRAS

Bad deflation - decrease in AD

Question 19

Inflationary spiral

Answer 19

Increase wealth → Increase AD → Prices go up → Workers demand higher wages to keep up → Businesses raise prices again to cover wage increases → Prices go up →…

Question 20

Deflationary spiral

Answer 20

Prices fall → Businesses make less money → They cut wages or lay off workers → People have less money to spend → Demand falls → Prices fall → …

Question 21

Why is inflation a problem?

Answer 21

• Redistributes income from savers to borrowers.
• Erodes fixed incomes (e.g., pensions).
• Devalues money.
• Creates “menu costs” for businesses.
• Causes “shoe leather costs” for consumers.
• Discourages saving.
• Encourages wage demands and industrial disputes.
• Reduces global competitiveness.

Question 22

Costs of High Inflation

Answer 22

• Uncertainty
• Redistributive effects (e.g., hurts savers, benefits borrowers)
• Erodes savings
• Damages export competitiveness
• Slows economic growth
• Inefficient resource allocation

Question 23

Costs of Deflation

Answer 23

• Uncertainty
• Redistributive effects
• Deferred consumption
• High cyclical unemployment and bankruptcies
• Increases real value of debt
• Inefficient resource allocation
• Policy ineffectiveness

Question 24

Redistributive effects

Answer 24

Redistributive effects occur when money shifts between groups.

Lenders lose from unanticipated inflation as repayments have less purchasing power, while borrowers benefit by repaying with devalued money.

Question 25

Costs/Effects of Inflation - 1

Answer 25

**Inflation reduces the purchasing power of money** Consumers are able to buy less and less with their incomes = fall in ‘real income’. The people most likely affected are: * Consumers on fixed incomes (e.g. pensions) * Consumers with life time savings (they will get eaten away) * Consumers whose wage rises lag behind price rises **Key term: inflation-linked incomes**

Question 26

Costs/Effects of Inflation - 2

Answer 26

Redistributes income and wealth

Question 27

Costs/Effects of Inflation - 3

Answer 27

Inflation can lead to balance of payments difficulties (this is the effect on their international competitiveness) If a country’s inflation rate is greater relative to the rest of the world then: * Prices of exports are more expensive to overseas buyers = discourages foreigners from buying * Domestic consumers encourage to buy imported goods = Domestic production fall --> unemployment * Imports > Export = current account deficit --> increased foreign debt.

Question 28

Costs/Effects of Inflation - 4

Answer 28

Inflation can distort the pattern of resource allocation and discourage investment and production. * Investors may prefer safe assets (e.g., gold, real estate) over capital goods. * Uncertainty about costs, competition, and government policies --> companies invest less * Less investment = fewer factories --> lower production, and fewer jobs in related industries * Banks may raise nominal interest rates to keep real rates positive.

Question 29

Effects of (bad) Deflation

Answer 29

**Unemployment:** Low demand leads to layoffs, potentially causing a deflationary spiral. **Deferred consumption:** Low consumer confidence reduces spending. **Low investment:** Reduced profits and business confidence discourage investment. **Rising debt burden:** Increased debt value leads to more bankruptcies. **Uncertainty:** Declining confidence levels and labor unrest. **Positive effect:** Potential improvement in productivity and output.

Question 30

Solving: demand pull inflation at less than full employment

Answer 30

Reduce AD: * Contractionary Monetary Policy * Contractionary Fiscal Policy

Question 31

Evaluation for Contractionary Fiscal Policy in solving demand pull inflation at less than full employment

Answer 31

Pros: * Inflation is solved Cons: * Economy is in recession * Unemployment increase * Difficult to cut government spending (vaccines, etc..)

Question 32

Evaluation for Contractionary Monetary Policy in solving demand pull inflation at less than full employment

Answer 32

Pros: * Increase price of money, directly address the cause of inflation Cons: * Increase interest rate --> decrease investment --> country may lose competitive advantage in production

Question 33

Solving: demand pull inflation at full employment

Answer 33

Increase max capacity of production --> Increase LRAS Supply side policies: * Remove minimum wage legislation * Subsidies to infant industry * Decreasing unemployment benefit * Reduce profit tax

Question 34

Solving: Cost push inflation

Answer 34

**Supply side policy (ways to decrease costs for firms):** * Reduce taxes (indirect, direct, profit) * Reducing wage rises * Reduce/remove minimum wage legislation **Contractionary Monetary Policy:** * Less demand --> less pressure to raise wages --> less costs * Reduce spending from high interest rate --> firms invest and spend less --> less costs