Inflation Flashcards
Inflation
Persistent rise in the general/average price level in the economy which has been sustained over a period of time.
Price stability
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).
Disinflation
Disinflation is when the inflation rate is falling but there is still inflation
Fall in inflation rate
Deflation
Persistent fall in the general/average price level in the economy which has been sustained over a period of time.
Hyperinflation
Rapid, excessive, out of control rise in price ( > 50% rise )
Measuring Inflation
Price index = (cost of today’s basket / cost of basket in base year) x 100
Measuring Inflation 2/Calculating Inflation
Price index
An average measure of price changes for a sample of consumer goods and services, excluding producer goods and services.
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.
B
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
B
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
D
Calculations you need to know
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
Formulas
Demand pull inflation
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
Causes of demand pull inflation
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).
Cost push inflation
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
Causes of cost push inflation
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
Good deflation vs Bad deflation
Good deflation - increase in SRAS
Bad deflation - decrease in AD
Inflationary spiral
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 →…
Deflationary spiral
Prices fall → Businesses make less money → They cut wages or lay off workers → People have less money to spend → Demand falls → Prices fall → …
Why is inflation a problem?
- 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.
Costs of High Inflation
- Uncertainty
- Redistributive effects (e.g., hurts savers, benefits borrowers)
- Erodes savings
- Damages export competitiveness
- Slows economic growth
- Inefficient resource allocation
Costs of Deflation
- Uncertainty
- Redistributive effects
- Deferred consumption
- High cyclical unemployment and bankruptcies
- Increases real value of debt
- Inefficient resource allocation
- Policy ineffectiveness
Redistributive effects
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.
Costs/Effects of Inflation - 1
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
Costs/Effects of Inflation - 2
Redistributes income and wealth
Costs/Effects of Inflation - 3
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.
Costs/Effects of Inflation - 4
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.
Effects of (bad) Deflation
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.
Solving: demand pull inflation at less than full employment
Reduce AD:
- Contractionary Monetary Policy
- Contractionary Fiscal Policy
Evaluation for Contractionary Fiscal Policy in solving demand pull inflation at less than full employment
Pros:
- Inflation is solved
Cons:
- Economy is in recession
- Unemployment increase
- Difficult to cut government spending (vaccines, etc..)
Evaluation for Contractionary Monetary Policy in solving demand pull inflation at less than full employment
Pros:
- Increase price of money, directly address the cause of inflation
Cons:
- Increase interest rate –> decrease investment –> country may lose competitive advantage in production
Solving: demand pull inflation at full employment
Increase max capacity of production –> Increase LRAS
Supply side policies:
- Remove minimum wage legislation
- Subsidies to infant industry
- Decreasing unemployment benefit
- Reduce profit tax
Solving: Cost push inflation
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
