Inflation And Deflation Flashcards
What is inflation?
a sustained increase in the general price level
What is deflation?
a sustained decrease in the general price level
What is disinflation?
a reduction in the rate of inflation
(the inflation rate falls but the price level is still rising, but at a slower rate)
What is the cost-of-living?
a measure of changes in the average cost for a household
of buying a basket of different goods and services
What is an inflation target?
a target set by the government which the central bank should aim to achieve
e.g. in UK it is CPI inflation = 2% +/-1% point
How do we measure inflation?
The ‘headline’ rate of inflation is the annual % change in the CPI
What are some other measurements of inflation?
• CPIH = similar to CPI but also monitors owner occupier housing costs (OOH), in its basket.
These are the costs associated with owning, maintaining and living in one’s own home.
• RPI – retail price index - the basket of goods/services includes some items not in the CPI, such as council tax & mortgage interest payments; it is often used to calculate increases in welfare benefits, pensions, index-linked bonds and wage negotiations; in a period of rising interest rates it typically gives a higher rate of inflation than the CPI.
• ‘Core’ inflation – sustained increase in prices of goods in the basket, excluding goods
such as energy, food, alcohol and tobacco which can be volatile.
Some limitations of using CPI to measure inflation?
• CPI inflation is only calculated for an ‘average’ family;
• It does not consider quality of goods/services
• Needs regular updating to reflect changes in patterns of spending
• International comparisons may not be accurate if other countries do not calculate
inflation in the same way
Costs of inflation?
• Shoe leather costs: costs of shopping around when prices change rapidly
• Menu costs: costs of redoing menus, parking changes, price labels & lists
• Fall in real incomes: if wages do not keep pace with prices, real incomes fall
• Uncertainty: consumers and businesses may reduce their spending causing unemployment and weaker growth
• Redistributional effects: savers get a lower real rate of return, those on
fixed incomes lose out, workers in the gig economy may not be able to
negotiate real wage increases; fiscal drag increases tax paid if thresholds
are frozen
• Loss of international competitiveness: weaker current account on the Balance of Payments as exports become relatively more expensive and imports relatively cheaper
• Increase in inflation expectations – people will aim for bigger pay rises if
they expect higher inflation, which can add to business costs and prices
• Danger of wage-price spiral – if workers demand big pay rises
Benefits of inflation?
• A low but steady rate implies aggregate demand is running ahead of aggregate supply, incentivising business investment and growth
• Reduces the real value of debt
• Allows negative interest rates
• Helps labour markets work more efficiently without a need to cut nominal wages because real wages can fall
• Makes malign deflation less likel
What is demand-pull inflation?
• Demand-pull inflation
- Inflation caused by excess AD in the
economy.
*Producers can raise
prices and increase
their profits
What is cost-push inflation?
Inflation caused by increases in the costs of production in the economy
*Can cause stagflation –
when economy stagnates
as price level rises
Causes of demand-pull inflation?
• Lower interest rates
• Lower income tax
• Rapid income growth
• High consumer confidence
• Positive wealth effects
• Easy credit (cheap and accessible credit)
• Depreciation of the currency
Causes of cost-push inflation?
• Rapid wage rises/higher labour costs
• Skill shortages
• Increasing input costs (raw material, energy)
• Higher commodity prices
• Food price inflation
• Indirect tax rises
• Depreciation of currency (imported inflation)
Inflation shock?
Sudden increase in prices
What can a fall in AD lead to? (Inflation/deflation?)
Deflation would occur; caused by a lack of AD in the economy.
*Producers have to reduce prices and their profits fall
*AD shifts inwards
What can an increase in short run or long run aggregate supply cause? (Inflation/deflation?)
Deflation caused by decreases in the costs of production in the economy;
*SRAS/LRAS would shift right
Costs of deflation?
• Lower AD causes over-supply
• Lower prices for goods and services cuts cash flow and profits for businesses; consumers may delay their spending; businesses may cut
investment
• Businesses reduce production; cyclical unemployment rises
• Rise in real value of debt
• Real interest rates may rise reducing consumption and investment
Benefits of deflation?
• Falling prices for consumers
• Increase in real incomes
• Increased spending power for those on fixed incomes
• Improved international competitiveness
• Falling asset prices could may housing more affordable for first time buyers
Causes of ‘benign’ deflation?
• Technological advances
• Improvements in productivity
• Falling price of commodity prices
• Falling price of energy prices
• Globalisation/economies of scale
• Cheaper/more skilled labour (perhaps from immigration)
Causes of ‘malign’ deflation?
• Negative demand shock (eg credit crunch in global financial crisis 2008-9)
• Global recession
• Appreciation of currency causing fall in net exports
• Falling asset prices (negative wealth effect)
• Contractionary fiscal and/or monetary policy
Difference between nominal and real rate of interest?
nominal is the actual rate paid while real rate is the nominal rate adjusted for inflation
eg nominal = 5%, inflation rate = 3%, real rate is approximately 2%
