inflation, deflation, disinflation

Question 1

inflation

Answer 1

a sustained rise in the general price level over time. this means that the cost of living increases and the purchasing power of money decreases

Question 2

deflation

Answer 2

the opposite of inflation, where the average price level in the economy falls.
there is a negative inflation rate

Question 3

disinflation

Answer 3

the falling rate of inflation.
this is when the average price level is still rising, but to a slower extent. this means goods and services are relatively cheaper now than a year ago, and the purchasing power of money has increased

Question 4

inflation objectives

Answer 4

-aim to keep inflation low and stable
-inflation target at 2%.
this aims to provide price stability for firms and consumers and helps them make decisions in the long run.
-price stability is measured with consumer price index (CPI)
-

Question 5

hyperinflation

Answer 5

when the rate of inflation is high and accelerating to the extent that it is out of control.
-growth of the money supply could cause this ( if bank of england printed more money, there would be more money flowing in the economy)

Question 6

calculating the inflation rate in the uk

Answer 6

-CPI is calculated by measuring the change in the value of a basket of goods and services.
-it measures household purchasing power with the family expenditure survey- it finds out what consumers spend their income on.
>from this a basket of good is created
>the goods are weighed according to how much income is spent on each item

Question 7

limitations of CPI when measuring inflation

Answer 7

• the basket of goods is only representative of the average household.
• hard to make historical comparisons since technology twenty years ago was different
• different demographics have different spending patterns
• CPI is slow to respond to new goods and services, even though it is updated regularly

Question 8

retail price index (RPI)

Answer 8

• alternative measure of inflation
  -unlike CPI, RPI includes housing costs, such as payments on mortgage interest & council tax - this more accurately reflects the cost of living.
  -tends to have a higher value than CPI due to the inclusion of housing costs
  -has been used for much longer than CPI, makes it better for comparisons over time
  -it is unique to the uk, not consistent with the european central banks inflation measurement like the CPI is.
  therefore CPI is more accurate for making comparisons between european countries

Question 9

calculating using index numbers

Answer 9

-used to make comparisons between years and to measure the magnitude of change over time.
>pick a base year (always has an index value of 100)
>raw number/ base year raw number x 100
-to make comparisons use percentage change of the index number
>%change= difference/original x 100

Question 10

causes of inflation

Answer 10

• demand pull

- cost push

Question 11

demand pull inflation

Answer 11

• this is from the demand side of the economy.
• when AD is growing unsustainably, there is pressure on resources.
• producers increase their prices and earn more profit.
• usually occurs when resources are fully employed

Question 12

triggers for demand pull inflation

Answer 12

-a depreciation in the exchange rate, which causes:
>imports to become more expensive
>exports to become more cheaper,
this causes AD to rise

• fiscal stimulus in the form of lower taxes or more government spending. this means consumers have more disposable income, so consumer spending increases.
• lower interest rates makes saving less attractive and borrowing more attractive, consumer spending increases.
• high growth in uk exports markets means uk exports increase & AD increases

Question 13

demand pull inflation diagram

Answer 13

• AD increases from AD to AD1
• prices increase from P to P1
• SRAS stays the same

Question 14

cost push inflation

Answer 14

-from the supply side of the economy, and occurs when firms face rising costs

Question 15

cost push inflation happens when…

Answer 15

• raw materials become more expensive.
  e. g. when oil prices rise
• labour becomes more expensive. this could be through trade unions
• expectations of inflation. if consumers expect prices to rise, may ask for higher wages to make up for this. this will trigger more inflation
• indirect taxes could increase the cost of goods such as cigarettes/fuel, if producers choose to pass the costs onto consumers
• depreciation in the exchange rate, which causes imports to become more expensive, which pushes up the price of raw materials
• monopolies using their dominant market position to exploit consumers with high prices

Question 16

cost push inflation diagram

Answer 16

• AD stays the same
• SRAS shifts to the left SRAS2
• quantity shifts to the left to q1 and p increases to p1

Question 17

evaluation of demand pull inflation

Answer 17

• considered less harmful than cost push inflation as it is associated with increasing AD and improving living standards.
• businesses could use increased profit margins to invest in new capital, increasing productive capacity in the future.

Question 18

evaluation of cost push inflation

Answer 18

-tends to be more harmful than demand pull inflation as it is associated with falling output (AS) (known as stagflation)

Question 19

high and stable inflation rates

Answer 19

• high inflation rate likely to cause more problems than a low rate.
• stable inflation rate is likely to cause fewer problems as it is easier for consumers, workers and firms to plan ahead

Question 20

affect on exports

Answer 20

depends on inflation rates abroad.

if inflation rates are higher abroad, exports may still be competitive

Question 21

different effects on different groups

Answer 21

may be harmful to some groups but benefical to others

e.g. the government as a borrower and beneficiary of fiscal drag may gain, tax payers and savers may lose

Question 22

consequences of inflation:

advantages of low inflation

Answer 22

• encourages people to spend more money before prices increase, keeping the economy moving
• price stability increases the ability for individuals and organisations to plan their finances.
• erodes value of debt over time
• businesses can reduce their real wage bill by raising money wages by less than inflation- may stop firms making workers redundant to cut costs

Question 23

consequences of inflation:

disadvantages of high inflation

Answer 23

• reduces consumer & business confidence, which can lower spending & lead to recession
• high inflation discourages investment as firms are less able to predict when their investment will be returned
• increases prices & reduces international competitiveness
• reduces the value of savings meaning groups like pensioners become worse off in real terms.
• real incomes fall with inflation, so workers will have less disposable income

Question 24

consequences of inflation:

disadvantages of high inflation (2)

Answer 24

menu costs- changing the labelling of prices incurs costs and happens more frequently at times of high inflation.

shoe leather costs- the costs of comparing prices from a variety of sellers.

inflationary noise- it becomes more difficult for consumers and businesses to decide what is a ‘fair’ price in time of high inflation, leading to inefficient choices.

if interest rates do not increase in line with inflation there may be a random redistribution of income from savers to borrowers

workers might demand higher wages, which could increase the cost of production for firms

fiscal drag may occur with tax bands not being adjusted in line with inflation and so workers pay may be dragged into higher tax bands

Question 25

causes of deflation

Answer 25

-a fall in aggregate demand:
>usually caused in recessions, when output and demand are decreasing.
this can be illustrated in the diagram. a fall in AD from AD2 to AD1 or AD4 to AD3 causes the price level to fall. however, usually falling AD causes disinflation rather than deflation.

• if the supply of money falls in the economy, there could be a fall in the average price level. this can be caused by a tightening of monetary policy, such as with higher interest rates
• significant spare capacity in the economy
• deflationary expectations, where customers anticipate falls in average prices and so postpone consumption. this exacerbates falls in AD, pushing prices down further
• an appreciating currency, reducing the price of imports

Question 26

causes of deflation evaluation

Answer 26

• short term falls in the price of inputs tend to be less damaging to an economy as these may encourage consumers to spend money while prices are lower.
• deflation caused by falls in AD tend to be more damaging as these falls can become in -grained in an economy

Question 27

consequences of deflation

Answer 27

1. there is an increase in the value of money
2. consumers choose to delay purchases as they expect prices to fall in the future. this reduces AD further- deflation ingrained in the economy
3. real value of debt increases
4. lower profit margins as businesses cut their prices
5. falling value of assets, such as houses, hits wealth
6. redistribution of income from debtors to creditors

Question 28

consequences of deflation evaluation

Answer 28

• a small amount of deflation for a short period caused by a fall in the cost of production, may be beneficial as consumers real wealth increases and they are able to increase their standard of living.
• however, when deflation becomes ingrained, it can have a damaging effect on the economy because of its impact on consumers expectations and the impact this has on AD

Question 29

bad deflation (malign)

Answer 29

-AD decreases, causing a
>recession/depression
>general price level- negative inflation
-a sign that average income (in households) is falling and people are spending less.

unemployment- low confidence
negative expectations- possible deflationary spiral
downward multiplier/accelerator- liquidity trap

Question 30

good deflation (benign)

Answer 30

-increased competition
-improvements in technology
-increased productivity
-globalisation- emergence of cheaper manufactured goods from china
-increase real disposable income & consumption (purchasing power & living standards)
people can consume more because prices have fallen , while the quality of products have improved

Question 31

quantitative easing

Answer 31

• helps stimulate the economy.
• since the interest rates are already very low, it is not possible to lower them much more. this means the bank had to adopt another measure: pumping money into the economy.
• the bank brought assets in the form of government bonds using the money they have created.
• this is then used to buy bonds from investors, which increases the amount of cash flowing in the financial system.
• encourages more lending to firms and individuals.
• the theory is that this encourages more investment, more spending and hopefully higher growth.
• a possible effect of this is that there could be higher inflation.