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

Refers to a 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

Types of Inflation - Demand pull inflation

Answer 14

This occurs when there are too many dollars chasing too few goods. When the amount of money that buyers of goods and services want to spend increases more than the supply of goods and services, then prices would be “pulled” upwards. Demand pull inflation is usually present when the economy is close to full employment.

The economy is growing too fast.
Spending too much money in the economy.

Question 15

Causes of demand pull inflation

Answer 15

Excess aggregate demand occurs when AD > economy’s production capacity, causing price rises.

If 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

Types of Inflation - Cost push inflation

Answer 16

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

Question 17

Causes of cost push inflation

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

• Increased wealth increases AD (e.g. rising housing prices)
• Higher prices mean costs of FOP rise (cost push pressures) and SRAS decreases
• High wages are an illusion of more spending and increase consumption (AD rises further)

Question 20

Deflationary spiral

Answer 20

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. This is known as a 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

Inflation 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 which discourages foreigners from buying
• Domestic consumers will be encouraged to switch away from local goods and into imported goods. Domestic production may fall, causing unemployment.
• More imports and less exports may cause a current account deficit, which may lead to 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.
• Firms invest less due to uncertainty about wages, raw material costs, competitiveness, and government policy.
• Lower investment reduces production and employment in capital goods industries, affecting the wider economy.
• 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

Salary

Answer 30

Reward hard workers

Encourages higher productivity