Inflation and deflation Flashcards
How do you calculate the CPI
- first, take a representative sample of the basket of goods used in the economy. These change, YoY, with some notable additions being antibacterial surface wipes in response to the pandemic, and meat free sausages, to reflect growing vegetarianism
- next, a weight is assigned to each of these products, depending on the proportion of income that the average household may spend on the good/service
- the price change for each good is calculated
- the price index is calculated by adding the price change to the base index of 100
- then the price index for each good is multiplied by the weight to give a weighted index
- the sum of the weighted index divided by the sum of the weights will give the rate of inflation
how to calculate percentage change
((final - initial) / initial )*100
what are the causes of inflation
- demand pull
- cost-push
- wage-price
- money supply
- explain what demand pull inflation is
- any factors that increase any of the four components of aggregate demand are demand side factors
- create excess demand within the economy, which pulls up the price level
- keynesian economists would argue that demand side policies will only cause inflation as economic output approaches YFE
explain cost push inflation
- relates to cost of production
- this is when the cost of production for firms increases, meaning that at a given price, firms are less willing and able to supply the same quantity of the good. Therefore, supply shifts leftwards, causing a higher equilibrium price and a lower equilibrium quantity
what is a wage price spiral
- when workers receive a wage hike, this increases the cost of production for firms, but it also means that workers on higher wages will have larger incomes, and so will demand more goods and services
- these factors causes prices to rise - leftward shift in SRAS and outward shiift in AD
- consequently, this increased price level erodes the real value of peoples wages, so workers won’t have seen an increase in their real wages.
- therefore workers will demand higher wages, reflecting the neverending cycle
explain the QToM
why does an increase in the money supply lead to an increase in inflation
The QToM in an economy states that there is a direct relationship between the quantity of money in an economy and the price level. According to QTM, if the money supply doubles, so does the price level
Fischer equation:
MV=PQ
- M = money supply
- V = velocity of circulation
- P = price level
- Q = real output
V is held constant because they believe that it is determined by institutional factors, such as how often workers get paid
Q is also assumed constant, because output tends to increase slowly (and it’s constant in the LR - classical economists believe that it’s vertical)
these factors held constant, an increase in the money supply will lead to an increase in the price level.
- this is because, when the money supply in the economy increases, the amount of money that householfs have increases, meaning that consumers have more moeny to spend on goods and services –> causes a rise in aggregate demand
- firms respond by increasing output
- increase in derived demand for labour
- leads to higher wages - this is because workers agree to overtime pay, and working longer hours
- increase in production costs and hence prices.
- initially workers agree to work for more hours because they see an increase in their nominal incomes
- however, as prices rise they realise that the real value of their income is being eroded, and that their real wage has not increased.
- therefore, they either leave the job market or demand higher wages, increasing price levels further.
how can the QToM be evaluated
- assumption that V (velocity of circulation) is constant does not hold
- it was argued by John Maynard Keynes that an increase in the money supply could cause a decrease in the velocity of circulation.
- for instance, during a recession, there may be an increase in the money supply of the economy, but fewer transactions were being made, meaning that the veolcity of circulation was lower
- this could be one of the reasons why implementing QE, which increases the money supply by giving liquid assets to firms in return for less liquid assets (corporate and govt bonds), did not lead to any significant inflation between 2009 and 2016
what are the costs of inflation
- uncertainty
- menu costs
- money illusion
- international competitiveness
- consequences of hyperinflation
- shoe leather costs
- unemployment and poor growth
- fiscal drag
what are the two causes of deflation
- benign
- malevolent
explain malevolent deflation
- inward shift in the AD curve
- when one of the components of aggregate demand falls
- fall in C, I, G, (X-M)
explain benign deflation
- when costs of production fall
- SRAS shifts right
- results in economic growth, hence why benign
what are the costs of deflation
Postponed spending
- delay spending as they expect prices to fall
- reduced
Real value of debt rises
- as wage rates decline in line with deflation in the economy, then the nominal debt outstanding rises as a proportion of your disposable income
- hinders willingness of firms to invest
real cost of borrowing rises
- 0% interest rate has a positive real rate that attracts saving
reduced profit margins
- firms must repeatedly reduce prices in order to stay competitive
- causes lower revenues and therefore lower profits
confidence and saving
- falling asset values, especially house prices, causes a negative wealth effect
- people feel that they are less well off, meaning that they are less willing to spend as much at a given price.
- this inward shift in AD leads to a negative price spiral that triggers a negative multiplier effect
what are the solutions to inflation
- contractionary fiscal policy
- monetary policy - increase interest rates
- wage controls - can limit wage increases
- price controls
- reducing money supply
- supply side policies - increasing productivity
“inflation is always preferable to deflation” - discuss this statement (20)
