Inflation Flashcards
What is inflation?
A persistent or continuing increase in the level of prices in an economy
What is deflation?
A persistent or continuing fall in the level of prices in an economy
What is disinflation?
When the rate of inflation is rising but less than before
What does the consumer price index measure?
Changes in the cost of living of a typical household
How is the consumer price index measured?
- weighting are placed on items based on their importance
- prices for 600 items are compared to give the final result
What is the inflation rate?
The annual percentage change in the consumer price index
What is the target inflation rate?
2%
What is price stability?
A sustained period of low and stable inflation
What are some issues with the measurement process of CPI?
- changes in quality are not taken into account
- special offers and second hand goods aren’t taken into account
- weightings will lag behind any changes in spending patterns
What is demand pull inflation?
When aggregate demand is growing at an unsuitable rate, leading to increased pressure on scarce resources and a positive output gap
When does demand-pull inflation become a threat?
When an economy has experienced a boom with GDP rising faster than the long run trend growth of expected GDP
When is demand pull inflation most likely to occur?
When there is full employment of resources and SRAS is inelastic
What are the main causes of demand pull inflation?
- low cost and increased availability of credit
- consumer confidence
- expectation on the economy
- depreciation of the exchange rate
- reduction of tax
- wealth effect
- disposable income
What is cost push inflation?
When firms respond to rising costs by increasing prices to protect their profit margins
What are the causes of cost push inflation?
- rising unit labour costs
- natural disasters
- depreciation in exchange rates: cost of imports will increase
- corporation tax
- expectations
- external shocks (commodity price fluctuations, acceleration in wages)
What are the costs of high inflation?
- lower purchasing power of money: makes households worse off
- erosion of savings (shoe leather costs); could mean a fall in living standards for those who live off of their savings eg pensioners, economically inactive, people begin to save less
- Lower export competitiveness: demand for exports will go down, worsening the current account position
- wage price spiral: as workers anticipate high inflation, they will bargain for higher wages. Cost of production (for firms) will increase. Extra costs will be passed down to consumers (causing higher prices). This increases inflation. Worker will then ask for higher pay rises (this create a cycle)
- consumer price spiral: when consumers anticipate high inflation, they bring forward their consumption by acting rationally and buying now to protect themselves from a future increase in price. This increases demand pull inflation
- fiscal drag: inflation is rising and workers are receiving higher income only in line with inflation. If workers get dragged into a higher tax band in a progressive income tax system they actually become worse off and their living standards decrease.
- ## inflationary noise: when the inflation rate is volatile (malleable). The price signalling function of market forces loses its value and significance. There is uncertainty in the economy; consumers put off their consumption, firms put off their long term investment plans - can hold back C and I and not help the economy to grow
What happens during a wage price spiral?
- Inflation rises
- Real incomes fall
- Workers bid for improved wages
- Leads to high labour costs
- Firms raise their prices
What happens during hyperinflation?
- Inflation goes out of control
- Huge amounts of money have to be printed to meet peoples demand for cash
- Money rapidly loses its worth
- There is a collapse in business and consumer confidence
- (Almost always) a new monetary policy will need to be created
When do price levels usually rise?
- when exports are low
- during economic growth
When do price levels usually fall?
- demand is low
- during a boom
What are the benefits of a low and stable inflation rate
- workers with higher wages
- consumption is natural (it will not be brought forward or delayed)
- firms are encouraged to increase output (because they can raise their prices and earn more revenues)
- can keep unemployment low in a recession
- reduces the real value of debt
- improvement of government finances (governments get a fiscal windfall) more VAT revenue as prices rice, benefits of extra taxation from fiscal drag
Which type of inflation causes benefits to outweigh the costs of high inflation?
Demand pull
What is stagflation?
Stagnant economic growth
High inflation
What are shoe leather costs?
The costs that people incur to minimise their cash holdings during high inflation
What are menu costs?
The costs incurred by a business when it changes the price it offers to customers
When does demand side deflation occur?
When AD shifts to the left
When does supply side (good) deflation occur
When SRAS shifts to the right
How does demand side deflation negatively affect the economy?
- comes with lower growth
- long-term and anticipated
How does supply side deflation (good deflation) positively affect the economy?
- comes with higher growth
- short-term and unanticipated
What happens in a deflation spiral?
