Inflation School Book

Question 1

Inflation

Answer 1

A persistent or continuing rise in the average price level

Question 2

Bank of England, the government and inflation

Answer 2

It’s the job of the Bank of England to set monetary policy interest rates, so that inflationary pressures are controlled and the target is reached
UK government has set an inflation target of 2% using the customer price index, CPI

Question 3

Demand, pull inflation
Why can A.D. shift to the right?

Answer 3

-decrease an interest rates, C, I, (X-M)
-Decrease in income/corporation tax ,C, I
-increase customer/business confidence, C, I
-Government spending, G
-Weak exchange rate, (X-M)

Question 4

Demand-pull inflation
What results in the A.D. shift?

Answer 4

Results in higher economic growth
The A.D. shifts, the rights, and there is greater pressure on existing factors of production to produce output
Existing factors of production becomes scarcer
Leads do an increase in wage (price of labour) , increase in the price of capital and an increase in the price of land resulting in an increase of cost of production for firms
Higher cost of production of firms leads to firms pass increasing prices for goods and services

Question 5

What are the contractionary demand-side policies to reduce demand pull inflation?

Answer 5

Contractionary monetary policy via an increase in interest rates
Contractionary fiscal policies via a cut government spending or an increased in taxation

Question 6

Is contractionary fiscal policy or contractionary, monetary policy more suited to reduce inflation

Answer 6

Monterey policies more suited to reduce inflation as monetary policy transmission mechanism has got a variety of avenues for interest rate charges to feed through into the economy
Monetary policies are more likely to have an effect on A.D. and getting inflation towards the target rate

Question 7

What happens if the policy successful in decreasing demand-pull inflation

Answer 7

If successful aggregate demand shifts left
Less demand, pull inflationary, pressure aka disinflationary pressure

Question 8

Conflict of objectives

Answer 8

Although there is a Successful reduction in demand-pull inflation it will result in the loss of some of the macro economic objectives if we use contractionary monetary policy.
This is because they’ll be lower economic growth and higher unemployment which could lead to a recession

Question 9

Impact on investment
Successful reduction in demand-pull inflation

Answer 9

High interest rates detract investments
Increase the cost of borrowing for firms by putting them off investing
Bad for short run and long run growth
Lower productivity and worsening the competitiveness of the economy

Question 10

Impact of the indebted
At a successful reduction in demand -pull inflation

Answer 10

Bad for businesses, with debts and household with debt
Household default on their loans, therefore their living standards suffer assets could be possibly taken away and it could possibly lead to homelessness in the extreme situations
Business could go bankrupt, creating unemployment

Question 11

Strong exchange rate
Following a successful reduction in demand -pull inflation

Answer 11

Widening the current account deficit
Higher interest rates could mean hot money inflows into our country
Hot money is savings that chase the best interest rates
Higher UK interest rates means savers move money to UK increasing the demand for the pound
Money inflow strengthening the pounds that could widen the trade deficit

Question 12

Reducing cost, push inflation
Implement/reduce inflation target

Answer 12

Implementing or reducing an inflation target will reduce the amount but wages rise in the economy
As workers will think that yearly inflation is going to be around the inflation target, and therefore their wage bargaining will be at that rate
Therefore, you can limit the extent to which wages rise on a yearly basis and bring the inflation rate down
If wages are the reason why they were getting a higher than target rate of inflation

Question 13

Reducing cost, push inflation
Reduce VAT/subsidies to firms

Answer 13

Subsidising firms to reduce their costs of production and bring inflation down
This will result, significant cost to the government worse than the government finances
This is very unlikely to happen

Question 14

Reducing cost, push inflation
Intervene in FOREX markets to strengthen the exchange rate

Answer 14

If it’s the week exchange rate, that’s driving the price of imported raw materials leading to higher cost, push inflation
In theory, central banks can intervene in foreign exchange markets in order to strengthen the exchange rate
A stronger exchange rate makes import cheaper. If imports are cheaper it can reduce the price of imported raw materials and reduce cost of production for firms who import raw materials.
This is very unlikely to happen as many countries I’ve got freely, floating exchange rates

Question 15

Causes of cost, push inflation

Answer 15

Causes of cost, push inflation are short-term parts of inflation
For example, there are high raw material prices due to a weak exchange rate

Question 16

Cost push inflation, resolving on its own

Answer 16

Exchange rate strengthen on their own and it can get rid of cost push inflation
Cost inflation is short term, and there are not any great policies to bring it down
Therefore, it makes sense to wait until cost. Push inflation reduces naturally.

Question 17

High long-term inflation rates

Answer 17

Long-term inflation rates, because the economy doesn’t have enough spare capacity
Very low levels of spare capacity means we consistently get high long-term rates of inflation

Question 18

Supply side policies

Answer 18

We need supply side policies to brew increase in the productive capacity of the economy to increase long run rates of economic growth
Therefore, to try and reduce the amount of pressure that’s on factors of production, consistently, and let’s reduce those long-term rates of inflation

Question 19

What are the two supply policies?

Answer 19

There is interventionist supply side policies
Market base supply side policies

Question 20

Effect of supplies policies

Answer 20

Chain them up to an increase in long run aggregate supply with that we see an increase in potential growth and we see reductions in our inflation rates over time
That’s we need when the economy has consistent higher than target rates of inflation because of a lack of spare capacity

Question 21

The downsides to supply side policies

Answer 21

-there is no guaranteed success in boosting LRAS
-It can be very expensive, especially the interventionist supply side policy
-There is a long length of time until these policies would work in shifting LRAS
If there was a need to get inflation rate down quickly, we are not necessarily going to see it

Question 22

Key evaluation points in what policies needed to bring down inflation
Consider :

Answer 22

-The type of inflation, although it is hard to know what inflation is pushing the inflation up the most, possibly use a range of these policies
- The rate of inflation

Question 23

Deflation

Answer 23

The persistent fall of prices in an economy in a year

Question 24

The two types of deflation

Answer 24

Demand side, deflation
Bad/Malignant deflation

Supply side deflation
Good/benign deflation

Question 25

Demand side, deflation

Answer 25

Comes with lower economic growth
Long-term and anticipated
If aggregate demand shifts left and a recession is caused in the economy, they take time to resolve
Therefore, if deflation is resulting as well, it could also last at the same time
This is an assumption

Question 26

Supply side deflation

Answer 26

SRAS shifts right due to a reduction in costs of production for firms in the economy
Comes with higher economic growth
Short term and unanticipated
SRAS shift to the right:
-Lower raw material prices
-Strong exchange rate, price of imported raw materials has decreased
As exchange rate doesn’t stay strong forever, we can quickly making supply side deflation short term
This is an assumption

Question 27

The difference between an anticipated and unanticipated deflation

Answer 27

Unanticipated deflation is beneficial so is short term
Long-term/anticipated deflation is a very dangerous thing for the economy

Question 28

Anticipated deflation
Deflation spiral
Delayed spending

Answer 28

Rational consumers are going to delay their spending(why buy now it’s going to be cheaper in a couple months)
This is bad for the economy as consumption is going to fall which is going to reduce AD
Businesses will slash their prices making deflation worse
The deeper consequence is not just the deflationary spiral , it’s that when AD falls, you get lower growth and higher unemployment

Question 29

Anticipated deflation
Deflationary spiral
Positive real interest rates

Answer 29

When there is deflation, real interest rates will always be positive
Real interest rates = nominal interest rate - inflation rate
The incentive is to save instead of to borrow and consume or borrow an invest
If there is more saving and less consumption and investment is going to reduce further causing more deflation
Even worse, we get lower growth and higher unemployment

Question 30

Anticipated deflation
Deflation spiral
Increased real value of debt

Answer 30

When prices are falling in the economy profits for businesses and income for households/workers are going to be falling at the same time
Profit decreases, if price falls as firms are making less revenue
This is going to hit consumers delaying their spending firms, aren’t going to make much profit if any
For workers that income are going to be falling as firms are making less profit and prices are falling in the economy
Decrease profits and incomes makes it harder to serve the debt
Debt is a fixed value and doesn’t change
If income is falling, it makes it harder to service that debts
Therefore, the real value of debts has risen

Question 31

Unanticipated deflation
Falling prices for customers

Answer 31

Falling prices for customers means they can buy at cheaper prices improve their living standards and they’re purchasing power increases

Question 32

Unanticipated deflation
Falling input prices for firms

Answer 32

Businesses can buy inputs at lower prices, reducing costs of production widen, their profit margins

Question 33

Evaluation points for judgement
Deflation

Answer 33

Consider whether deflation is anticipated or unanticipated
The cause of the deflation

Question 34

Shoe leather costs

Answer 34

Resources wasted when inflation encourages people to reduce their money holdings
This can be substantial

People waste their time when there is inflation and keep money, they have on them to a minimum cash loses its value during inflation, so they keep it in a bank
One of the disadvantages of inflation

Question 35

Menu costs

Answer 35

Costs of changing prices
Inflation - increases menu costs that firms must bear
One of the disadvantages of inflation

Question 36

What are the costs of high inflation?

Answer 36

-Lower purchasing power
-Erosion of savings
-Lower export, competitiveness
-Wage/consumer price spirals
-Fiscal drag
-Inflationary noise

Question 37

What are the benefits of low and stable inflation?

Answer 37

-Workers with higher wages
-Consumption is natural
-Firms encouraged to increase output
-Can keep unemployment low in a recession
-Reduces real value of debt
-Improvement of government finances

Question 38

Costs of high inflation
Lower purchasing power

Answer 38

If incomes are not rising in line with inflation workers are worse off
This can affect their ability to buy basic sustaining goods and services and affect living standards
Those on the lowest incomes can drive them into poverty

Question 39

Costs of high inflation
Erosion of savings

Answer 39

Interest rates are not rising in line with inflation
The interest rates you might be receiving on your savings as much less than the inflation rates. Therefore your savings are losing their value.
This is about savings, like the unemployed, old age, pensioners which causes a fallen living standards
Shoe leather cost -
People spend time looking for other bank accounts which give higher rates of interest.
This takes time and effort in research, which is an opportunity cost where they could’ve been working/earning an income

Question 40

Costs of high inflation
Lower export competitiveness

Answer 40

If inflation is high, and one country relative to others that countries exports are going to be less internationally, competitive reducing demand for exports/revenue from exports
This worsen the current account position possibly harming economic growth
This is especially bad for trade, relying countries for economic growth

Question 41

Costs of high inflation
Wage/consumer price spirals

Answer 41

Risk of high inflation, becoming anticipated and spiralling, potentially creating hyperinflation, happens in two ways
-Wage price spiral
-Consumer price spiral

Question 42

Cost of inflation
Wage price spiral

Answer 42

As inflation is high, and Work is anticipated, they’ll bargain for higher wages to keep up with the cost of living asking for inflation equally pay
If firms grant, this, it increases cost of production
Firms pass on high cost via higher prices, increasing inflation
Workers then asked for higher pay leading to an inflation spiral

Question 43

Costs of high inflation
Consumers price spiral

Answer 43

When there is high inflation consumers are anticipating
The rational thing to do is to bring forward your consumption, even if you don’t need this good right now to protect from high future inflation
If all customers act rationally, it’s all up AD inflation leading to an inflation spiral
Menu costs -
Inflation is high, and rising firms will have to continually print menus/price catalogues, which can be costly

Question 44

Cost of high inflation
Fiscal drag

Answer 44

When inflation is rising and workers are receiving higher incomes, but only in line with inflation and cost-of-living
In real terms, the workers are not better off
The pay rise may mean they get dragged into a higher tax band in a progressive income tax system
Paying higher rates of tax means living standards will decrease
The only happens if tax bands don’t rise in line with inflation

Question 45

Costs of high inflation
Inflationary noise

Answer 45

When inflation rate is volatile prices will go up and down
This makes consumers uncertain, and they put off their consumption
Firms put off their long-term investment plans, which is not good and holds back economic growth

Question 46

Benefits of low and stable inflation
Workers with higher wages

Answer 46

Workers can bargain for high wages, if it’s in line with inflation or even a nominal pay rise(which does not match inflation)
This is good for morale and productivity of the workers

Question 47

Benefits of low and stable inflation
Consumption is natural

Answer 47

Won’t get consumers bringing forward their spending or delaying it, trying to anticipate inflation
Consumption is fluids which is good for economic growth

Question 48

Benefits of low and stable inflation
Firms encouraged to increase output

Answer 48

They can raise their prices and earn more revenue

Question 49

Benefits of low and stable inflation
Can keep unemployment low in a recession

Answer 49

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Normal for workers to be sacked in a recession due to their revenues falling and to keep costs under control firms I want to get skilled and productive workers as they are hard to get back

Question 50

Benefits of low and stable inflation
Reduces real value of debt

Answer 50

Work is bargain for a pay rise, so wages increase
Firms might be able to make up more profit when there is higher inflation
Wages profit and revenues rise, making it easier to service debt
Is it because that is fixed and doesn’t change

Question 51

Benefits, a low and stable inflation
Improvement in government finances

Answer 51

Government get a fiscal windfall when there is inflation
Any taxes based on nominal values of good centres services, for example, VAT as prices rise, governments, collect more revenue
Governments also might not be able to spend as much on public services

Question 52

Evaluation
When our costs of inflation greater than the benefits
Consider :

Answer 52

-rate - low/stable means more benefits
Higher inflation rates means more costs

-Cause - demand pole inflation is more favourable than cost. Push inflation.
This is because demand pole inflation, least a higher economic growth and low unemployment cost push inflation leads to lower growth and higher an employment
Demand, pull inflation is also easier to solve using contractionary supply side policies

-Duration - long-term high rates can become anticipated and spiral into hyperinflation

• anticipated and unanticipated

-Stability - more volatile inflation is risking, inflationary noise harming consumption and investment

Question 53

Current account deficit

Answer 53

The amount by which countries imports exceed the value of the countries exports

Question 54

Trade deficit

Answer 54

The country is importing more goods and services and exporting