Lesson 9 - Inflation And Deflation

Question 1

What are the 4 types of inflation?

Answer 1

• demand pull
• cost push
• imported
• monetarist explanation

Question 2

What is demand pull inflation?

Answer 2

• increase in aggregate demand
• begin to suffer supply constraints
• costs rise for firms
• they reflect this with an increase in prices (inflation)

Question 3

What is cost push inflation?

Answer 3

• increases in costs for reasons independent of demand
• reflected in an increase in prices (inflation)

Question 4

What is imported inflation?

Answer 4

• weak currency
• increases the price of imports
• leads to the increase in the price of domestic goods as they try to compete
• leads to imported inflation

Question 5

What is the monetarist explanation for inflation?

Answer 5

• if the stock of money increases, more of it is spent on goods and services
• this boosts AD
• if LRAS does not respond with an increase, then price levels will increase, leading to inflation

Question 6

What are the 4 causes of inflation?

Answer 6

• too much demand
• rising costs
• weak pound
• increase in the money supply

Question 7

What are the consequences and solutions for demand pull inflation?

Answer 7

Consequences
- fall in living standards (real wages fall - leads to the wage squeeze - less spending power)

Solutions
Short run - contractionary fiscal policy (lower government spending and increase taxes)
Long run - supply sides policies to boost LRAS (training/education, lower corporation tax, invest in infrastructure)

Question 8

What are the consequences and solutions for cost push inflation?

Answer 8

Consequences
- inflationary noise (leads to uncertainty and decreases investment since firms are less likely to take risks in inflationary environments)

Solutions
- reduce union power (make it harder to strike)
- free up labour markets (make it easier to hire and fire)

Question 9

What are the consequences and solutions for imported inflation?

Answer 9

Consequences
- expectations adjust
- leads to the wage price spiral (pushing for higher wages - increase in costs - increase in prices)

Solutions
- strengthen the pound (increase interest rates - reduce AD, lowering inflation)(buy pounds using our foreign currency reserve to increase its value)

Question 10

What is the money illusion?

Answer 10

People think that the nominal value of their money equates to its real value, so they think that they have more spending power than they actually do

Question 11

What are the consequences and solutions for the monetarist explanation of inflation?

Answer 11

Consequences
- arbitrary redistribution (wealth is redistributed from lenders to borrowers, since they benefit from the fall in the value of money, and therefore their debt)

Solutions
- reduce the money supply (selling bonds)

Question 12

Define the concept of deflation

Answer 12

• sustained fall in the general price level
• associated with recessions and depressions

Question 13

What is the impact of deflation on debts?

Answer 13

• rise in the value of money, so the value of debt increases
• shatters confidence
• leads to the debt trap (people borrow even more money to pay off their previous debt)

Question 14

What is the impact of deflation on confidence?

Answer 14

UK is a nation of home owners, so increases in the value of money has a big impact on confidence
- house prices will fall, shattering confidence