Inflation

Question 1

Inflation can be caused by cost-push factors

Answer 1

1. Cost-push inflation = nflation which is caused by the rising cost of inputs to production.
2. Rising costs of inputs to production force producers to pass on the higher costs to consumers in the form of higher prices, which causes the aggregate supply curve to shift to the left. For example:
   a) A rise in wages above any increase in productivity
   - if wages make up a large proportion of a firm’s total costs then this could => a significant rise in prices
   - Price rises could => further wage demands, which in turn could => price increases and son on. (wage-price spiral)
   b) A rise in the cost of imported raw materials
   - If the world prices of inputs rise then, in the short run, producers will pay the higher cost and set higher prices. This is how price increaes in world commodity markets can => higher domestic inflation.
   - Also if a country’s currency decreases in value then producers will have to pay more for the same imports.
   c) A rise in indirect taxes
   - If the govt raises indirect taxes, this will increase costs and, in turn, prices.
   - If a good is price inelastic then more of the cost of the tax will be passed on to the consumer

Question 2

Inflation can Also be caused by Demand-pull Factors

Answer 2

• Demand-pull inflation = inflation which is caused by excessive growth in AD compared to supply. This growth in demand shifts the AD curve to the right from AD to AD1, which allows sellers to raise prices. It could be caused by:
  1. High consumer spending or high demand for exports
• HIgh consumer spending could be caused by high levels of consumer confidence in consumers’ future employment prospects. Low interest rates encourage cheap borrowing and greater spending.
• High foreign demand for exports could be caused by rapid economic growth in other countries.

2. If the amount of money in the economy is not matched by the output of goods and services, this can => a rise in prices. This might be the case, for example, when interest rates are low and consumers are spending more.
   - Monetarist economists believe that excess money = biggest cause of inflation.
3. Bottleneck shortages
   - If demand grows quickly at a time when labour and resources are already being fully used, then increasing output may => shortages. These shortages will cause prices to rise and firms’ costs to increase.
   - Price rises caused by shortages in one area of the market may be copied by other markets, leading to more general inflation.

Question 3

Quantity Theory of Money

Answer 3

1. The quantity theory of money is based on Fisher’s equation of exchange = money supply x velocity of money = price level x aggregate transactions.
2. On the left-hand side is M (total amount of money in the economy and V (the speed a which the money is spent). On the right hand side is P (price level) and T (the total amount of transactions in the economy).
3. Monetarists argue that, in the short run, V and T are unlikely to change, so any increases in P, the price level, will be directly caused by an increase in M, the money supply. Both sides of the equation are assumed to be equal to each other, so any increase in the money supply (M) will create the same percentage increase in the price level (P).
4. To avoid inflation, monetarists believe that the money supply neeed to be strictly controlled.

Question 4

There are several Costs and Consequences of Inflation

Answer 4

1. Inflation will cause the standard of living of those on fixed, or near-fixed, incomes to fall. This will have the biggest impact on those in low income employment or on welfare benefits.
2. A country’s competitiveness will be reduced by inflation as exports will cost more to buy and imports will be cheaper. If exports fall and imports rise, then this could create a deficit in the b of p and increase employment.
3. Inflation discourages saving because the value of savings falls. This makes it more attractive to spend before prices rise further.
4. A reluctance to save creates a shortage of funds for borrowing and investment, which means that it’s harder for firms to make improvements, e.g. buy new machinery. If interest rates go up to reduce inflation, this will also reduce investment.
5. Inflation creates uncertainty for firms as costs will reduce investment - harming future growth.
6. Inflation can cause show leather costs, which are the costs of the extra time and effort taken by consumers to search for up-to-date price information on the goods and services they’re using, and menu costs, which are the extra costs to firms of altering the price info they provide to consumers.
7. An extreme case is hyperinflation, where inflation grows very quickly to very high levels. It’s often the result of governments creating too much money (e.g. because of a war crisis).

Question 5

Deflation isn’t a good thing

Answer 5

1. When the rate of inflation falls below 0% its called deflation. Although there are many costs and consequences of inflation, deflation isn’t very good either.
2. Deflation is often a sign that the economy is doing badly, as it’s usually caused by falling AD and increased unemployment.
3. However, deflation can also be caused if firms’ costs fall and these benefits are then passed on to consumers in the form of lower prices.
4. Deflation can cause big problems. E.g: if consumers think that prices are falling then they may choose not to spend in the hope that prices will fall further.
5. Less spending and lower prices will also mean lower profits for firms and reduced economic growth.

Question 6

Inflation of 2% is Acceptable

Answer 6

a) In the UK, the Bank of England and the government consider low and stable inflation to be acceptable. Excessive inflation (above 2%) is undesirable & can cause problems mentioned above.
b) The government uses a combination of monetary policy, fiscal policy and supply-side policies to try to keep the rate of inflation at 2%. However, to achieve this the government has to make trade-offs between their inflation target and their other three main economic objectives.
c) Some economists, called monetarists, believe that bringing down inflation in the short run will help the government in the long run to achieve the main economic objectives.