INFLATION AND DEFLATION Flashcards
what is inflation
inflation is the situation where there is a sustained increase in the general price level of an economy
what is the consumer price index
measures the change in the price of a fixed basket of goods and services commonly purchases by the average HH over time, wrt a selected base year
why does demand-pull inflation occur
demand-pull inflation occurs when the economy is producing at full productive capacity of close to it. When there is an increase in AD form AD1 to AD2, profit-maximising firms will increase their production in order to meet the increased demand for goods and services. However, the closer the economy is to full capacity, the less efficient the FOPs used for production are due to resource scarcity. This means that per extra unit of output, more labour and resources are required to produce it. Hence, firms are only willing to produce the extra output if a higher price can be obtained for the good. Thus, the rise in AD will lead to an increase in national output from y1 to y2 but also increase the price level from p1 to p2. When AD rises further and Yf is reached, continuous increase in AD only increases the GPL.
how does wage push cause inflation
wage push - countries with shrinking labour forces due to aging population or govt policies that limit foreign inflow of labour which can drive up wage rates
- trade unions pushing up wage rates independently of the DD for labour
Thus, when wage rates rise faster than the rise in labour productivity, inflation may set in due to the rising unit labour cost
how does increase in price of imported inputs cause inflation
imported inflation - increase in the price of imported inputs which are key inputs to produce a variety of products. e.g increasing the price of crude oil. relevant for countries that are dependent on imported inputs
depreciation of foreign exchange rate - depreciation of a countries currency causes increase in the price of imported foodstuff, capital goods and raw materials in terms of local currency meaning an increase in UCOP
how does tax-push inflation cause inflation
tax-push - increase in indirect taxes like GST will increase the UCOP as producers, to protect their profit margins, pass on some of the taxes to consumers by raising prices causing an increase in GPL. This increases the cost of living which may cause workers to ask to higher wages which cause another round of increase in UCOP.
how does an increase in UCOP cause cost-push inflation
increase in UCOP means that profit-maximising firms are now only willing to produce at the same output level if they receive a higher price for the goods. Thus, AS falls as represented by a upward shift in the horizontal portion of the AS curve since firms are passing on the increase in unit costs to the consumers. As a result, the GPL increases form P1 to P2.
why is a low and stable inflation rate good for SOL
when inflation is high, the cost of living increases as the price of all goods including necessities increase. Assuming nominal income remains constant, then the real income of HHs will have decreased as the same nominal Y can now buy less GAS meaning their purchasing power has decreased so real Y decreases. As a result, HHs can only consume less goods and services meaning their material SOL decreases. A high inflation rate also means that the value of ones savings will erode since the nominal sum of savings is constant. Given that the savings are used for retirement or future education, then HHs future SOL will also be affected
why is a low and stable inflation good for investment
a low and stable inflation rate means that investment is encouraged. Assuming nominal ir remains unchanged, inflation reduces the real interest rates which is given by nominal ir - inflation rates and hence reduces the cost of borrowing. Additionally, a low and stable inflation rate creates a safe and stable macro environment that eliminates uncertainty as firms can take cues from the price mechanism in determining whether there is growing demand for their products. with more certainty, firms are likely to invest. In the LR with higher rates of investment, the capital stock of a country would increase assuming that the net investment exceeds capital depreciation. This causes a countries productive capacity to grow, improving its LR potential growth
why is a low and stable inflation good for maintaining a healthy BOT
when ir are high, the BOT is unfavourable. Assuming that the change in GPL of other countries are relatively low then a high inflation would mean that the price of exports increases. Assuming that the PED of exports is greater than 1, this would lead to a mtp decrease in the Qd of exports. Since revenue = PxQx, overall export revenue decreases. Exports are also consequently cheaper compared to domestically produced goods so HHs purchase more imports leading to an increase in import expenditure. Hence X-M actually worsens which is what the govt wants to avoid
what is deflation
deflation is the sustained decrease in GPL
how does a decrease in demand lead to demand-side deflation
When AD decreases due to … , firms respond to the decrease in demand by reducing their output, employing less FOPs including labour which is a derived DD. As such, this rise in unemployment means that firms will better be able to get the resources that they need resulting in more efficient factor combinations and falling UCOP. Hence, they are willing to sell at lower prices. Upon seeing the fall in GPL, it is also likely that HHs will postpone their consumption of goods and services as they expect prices to drop further, resulting in AD dropping further.
how does rising AS lead to supply-side deflation
Assuming that a factor changed e.g. decrease in price of key inputs, UCOP of goods falls such that AS rises. Firms will have to respond by increasing the quantity supplied at each price level. With excess AS, firms have to cut prices to stimulate spending and reduce excess suply hence GPL falls.
how does demand-side deflation and supply side deflation affect the SOL of HHs
when there is demand-side deflation, the nominal wage of workers is likely to stay fixed in the short run meaning that material SOL in the short run increases as their real income increases. However, in the LR, HHs nominal Y will eventually fall and the impact on a HHs income is dependent on the rate of decrease of nominal Y against GPL.
In addition, deflation is likely to lead to decreases in AD because HHs hold back consumption in anticipation of further decrease in P. resulting fall in national output will lead to decrease in HHs real income and a decrease in mSOL.
When there is supply side deflation, with nominal income remains unchanged in the SR due to the presence of wage contracts, a decrease in GPL would mean an increase in real income. LR, nominal Y like wage will be rising as firms bid up wage rates in order to employ more workers to increase output. While is slows down the fall in unit cost that caused the deflation, as long as GPL is falling and nominal income is constant or unchanged then HHs will have higher PP and ability to consume goods to mSOL increases
How does deflation negatively impact a countrys macro performance
When there is prolonged deflation, consumers and firms delay spending on C as they anticipate future P decrease and wish to take advantage of them. Since real interest rates = nominal ir - inflation rates then deflation would cause real ir to increase which is the opp cost of consumption and the cost of borrowing for investments. Hence, AD decreases resulting in negative economic growth. With less investments, the net investments may now be lower than the capital depreciation meaning that the countrys captial stock is decreasing and as a result its productive capacity decreases. ( can talk about the reverse k process as well )
