Inflation + Deflation

Question 1

What is the inflation target

Answer 1

2% (+/-1) set by the Bank of England (monetary policy)

• The rate of inflation is measured by the annual percentage change in consumer prices

Question 2

Inflation

Answer 2

Is a rise in the price level measured over a given period of time

Question 3

Deflation

Answer 3

A fall in the price level measured over a given period of time

• The annual percentage change in consumer prices is negative

Question 4

Disinflation

Answer 4

Is a fall in the rate of inflation measured over a period of time

• Prices are still rising but at a slower rate, for example a drop in the annual inflation rate form 6% to 2%

Question 5

Demand pull inflation

Answer 5

Is a rising price level caused by an increase in aggregate demand, shown by the shift (outwards) of the AD curve.

• Demand pull inflation is usually associated with an increase in real GDP - i.e. economic growth, and an increase in employment levels in an economy.

Question 6

Demand pull inflation diagram

Answer 6

Question 7

Cost push inflation diagram

Answer 7

Question 8

Cost push inflation

Answer 8

Is a rising price level caused by an increase in the costs of production shown by a shift in the SRAS curve to the left (inwards).

• With cost push inflation, output of goods and services and employment tend to fall - this is because a rise in costs often leads to a fall in business profits and planned investment spending.

Question 9

Narrow monetarism

Answer 9

Increases in the money supply are the prime causes of inflation

Question 10

Broad monetarism

Answer 10

Narrow monetarism but with a focus on the virtues of the free market in resource allocation

Question 11

Quantity theory of money

Answer 11

The oldest theory of inflation which states that inflation is caused by a persistent increase in the supply of money

Question 12

Causes of demand pull inflation

Answer 12

• Caused by excess aggregate demand
• Often linked to a money and credit boom (easier to borrow money)
• Economy close to full capacity (inelastic AS)
• Positive output gap (AD > potential GDP)

Question 13

Causes of cost push inflation

Answer 13

• Rising wage costs in labour market
• Increasing raw material and component costs from domestic and overseas suppliers
• Rising import prices due to a falling exchange rate- this increases import costs

Question 14

The rationing function

Answer 14

When there is a shortage of a product, price will rise and deter some consumers from buying the product.

Question 15

The signalling function

Answer 15

Changes in price provides information to both producers and consumers about changes in market conditions

Question 16

Adam’s smith’s - invisible hand

Answer 16

The invisible hand is a metaphor created created by Adam Smith to illustrate how the wealthy, by following their individual self interest unwittingly stimulate the economy and assist the poor

Question 17

Malign deflation (bad)

Answer 17

A fall in the price level due to fall a in aggregate demand

Question 18

Benign deflation (good)

Answer 18

A fall in the price level due to increases in aggregate supply (usually due to falling costs of production).

Question 19

Benign deflation diagram

Answer 19

Question 20

Malign deflation diagram

Answer 20

Question 21

Impacts of deflation

Answer 21

Deflation is a sustained decrease in the overall price level of goods and services in an economy. It can be economically damaging for a number of reasons:

Decrease in consumer spending: When prices are falling, consumers may delay purchases in the hope of getting a better deal in the future. This can lead to a decrease in overall consumer spending and economic activity.

Increase in real debt burden: Deflation increases the real value of debt, making it more difficult for borrowers to repay their loans. This can lead to defaults, foreclosures, and bank failures.

Difficulty for firms to raise prices: Deflation can make it difficult for firms to increase prices, which can lead to decreased profits and a decrease in investment.

Difficulty in monetary policy: Central banks typically use monetary policy tools such as interest rate adjustments to stabilize the economy. However, deflation can make it difficult for central banks to stimulate the economy with monetary policy because interest rates cannot normally fall below zero. This is called the zero bound.

Confidence and saving - Falling asset prices such as price deflation in the housing market hits personal sector wealth and confidence.

Question 22

Domestic causes of inflation

Answer 22

Inflationary pressures within the domestic economy come - for example - from rising wage costs and increases in the costs of component parts of raw materials

Question 23

External causes of inflation

Answer 23

• These are inflationary pressures from outside a particular country - for example - arising from an increase in the global price/ cost of energy and other inputs
• Movements in the exchange rate of a country’s currency can also affect inflation. For example, if the currency weakens (becomes cheaper in terms of other currencies) then that will cause imported goods (e.g. raw materials) to become more expensive, pushing up domestic production costs

Question 24

Economic policies to avoid price deflation

Answer 24

Lower interest rates (increase consumption + investment) and quantitative easing
- Cheaper loans for businesses and households
- Expanding the supply of credit in banking system

Fiscal stimulus measures -controlled by government
- Higher government spending
- A rise in government borrowing to inject demand into the circular flow
- Lower direct taxes to increase disposable income and spending

Other measures to stimulate aggregate demand
- Attempts to lower the value of the exchange rate (perhaps via central bank intervention to sell their currency in the market)
- Higher taxes on savings to encourage consumption

Question 25

The monetarist theory of inflation

Answer 25

Quantity theory of money states that inflation is caused by a persistent Increase in the money supply.

Question 26

Inflation - Equation of exchange

Answer 26

MV = PQ

M - money supply
V - velocity of circulation of money
P - price level
Q - quantity of output