Inflation + Deflation Flashcards
What is the inflation target
2% (+/-1) set by the Bank of England (monetary policy)
- The rate of inflation is measured by the annual percentage change in consumer prices
Inflation
Is a rise in the price level measured over a given period of time
Deflation
A fall in the price level measured over a given period of time
- The annual percentage change in consumer prices is negative
Disinflation
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%
Demand pull inflation
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.
Demand pull inflation diagram
Cost push inflation diagram
Cost push inflation
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.
Narrow monetarism
Increases in the money supply are the prime causes of inflation
Broad monetarism
Narrow monetarism but with a focus on the virtues of the free market in resource allocation
Quantity theory of money
The oldest theory of inflation which states that inflation is caused by a persistent increase in the supply of money
Causes of demand pull inflation
- 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)
Causes of cost push inflation
- 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
The rationing function
When there is a shortage of a product, price will rise and deter some consumers from buying the product.
The signalling function
Changes in price provides information to both producers and consumers about changes in market conditions
Adam’s smith’s - invisible hand
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
Malign deflation (bad)
A fall in the price level due to fall a in aggregate demand
Benign deflation (good)
A fall in the price level due to increases in aggregate supply (usually due to falling costs of production).
Benign deflation diagram
Malign deflation diagram
Impacts of deflation
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.
Domestic causes of inflation
Inflationary pressures within the domestic economy come - for example - from rising wage costs and increases in the costs of component parts of raw materials
External causes of inflation
- 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
Economic policies to avoid price deflation
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
The monetarist theory of inflation
Quantity theory of money states that inflation is caused by a persistent Increase in the money supply.
Inflation - Equation of exchange
MV = PQ
M - money supply
V - velocity of circulation of money
P - price level
Q - quantity of output
