Inflation and Deflation Flashcards
What is inflation?
Inflation: The sustained rise in the average price level in a country over a period of time
How is inflation measured?
Normally using the CPI- Consumer Price Index
What is the inflation target?
Depends on the Country
The UK is 2% CPI
How do you measure inflation?
The CPI is a weighted price index used to measure the change in prices of a typical basket of goods and services.
The contents of the baskets are priced each year.
Changes in weighting reflects changes in spending behavior (the more that is spent the higher the weighting)
In 2008 fruit smoothies, muffins and USBs were included in the Basket
Microwaves, 35mm camera film, and CD singles were removed.
How do you calculate an index and inflation?
Add up all the weighted average of the goods in the basket and set the total equal to 100.
This is now your base year that all the subsequent years will be measured against. It compares year to year very easily.
20/20 X 100= 100
More information on the random page (you know which)
What is weighting?
Households do not spend the same proportion of their income on each item in the basket of goods.
So a 2% rise in the price of cinema tickets is not going to matter to them as much as a 2% rise in the price of groceries.
To make the CPI more accurate each category is given a weighting that accounts for the proportion of income spent on each category
Two main reasons for inflation?
Cost-push inflation: Higher costs of production forcing firms to raise their prices in order to maintain their profit levels. This could be caused by wages or raw materials prices. It also imports inflation if it’s caused by rising prices internationally.
Demand-pull inflation: Higher levels of demand in the country driving up price levels.
Consequences of inflation?
There are a significant number of negative consequences associated with high levels of inflation.
Loss of purchasing power:
Can’t buy as many items as you did before.
It increases the costs of production and reduces profits margins.
It reduces the price competitiveness of exports
Your goods look comparatively more expensive than other countries and people won’t want to buy.
Devalues savings: The money that you are saving loses value, due to banks not offering inflation rates.
It creates economic uncertainty:
Most economic goals are around this idea of certainty.
People who are nervous don’t spend money, don’t invest.
Companies don’t know what their costs will be in a few years’ time.
It makes it very hard to plan
Who benefits from inflation?
Borrowers and those in debt
As inflation increases the value of the money you have to repay is worthless.
If your interest rates are 4% and inflation is 6% then the real interest rate is actually -2%
Lenders do not like high inflation
What is deflation?
Deflation: A sustained fall in the average price levels in the economy is usually measured with the CPI.
What is a good type of deflation?
The inflation rate will be negative
There is a good deflation and bad deflation
The better type of deflation is caused by increased Aggregate Supply in the country. It’s usually accompanied by higher output and employment.
Deflation vs Disinflation
Do not confuse deflation with disinflation, which is just a fall in the inflation rate.
What is a bad type of deflation?
The worse type of inflation comes from a fall in AD
A fall in AD drives down prices levels but it also leads to lower economic growth and therefore higher unemployment.
This can cause a deflationary spiral as more people lose their jobs and incomes fall and consumption will fall too. This of course leads to a further fall in AD and the cycle continues.
Consequences of deflation?
If it is caused by a fall in AD it could lead to higher unemployment.
Firms receive lower sales revenue.
The costs to those in debt grow
Consumer confidence may be hurt if they are worried about the health of the economy.
Benefits of deflation
Purchasing power goes up.
You can buy more with the same amount of money.
