Macro 9 - Inflation, Deflation, Disinflation. Measures, Causes and Costs

Question 1

2 ways to measure inflation

Answer 1

> Consumer Price Index

>Retail Price Index

Question 2

Basket of Goods

Answer 2

> 650 goods/services
Each product is weighted according to % of household income spent on it.
Average weighted increase.

Question 3

RPI

Answer 3

> RPI is slightly higher as it takes into account mortgage rates, council tax, so is slightly higher.

Question 4

Why is calculation inflation over time difficult?

Answer 4

1. Sometimes price rises as the quality of a good or service increases, not due to inflation.
2. Considers the ‘average’ household. May be an ‘atypical’ household.
3. Housing costs vary dramatically due to location.

Question 5

Important evaluative comment for essays on inflation

Answer 5

> If the economy is operating at full capacity a shift in AD will have a bigger effect on inflation.
‘Depends on where the economy is operating’.

Question 6

Real wage formula

Answer 6

(nominal wage x old CPI)/ new CPI.

Question 7

Cost-push inflation definition

Answer 7

> Inflation caused by an increase in prices of factor inputs.

>AS.

Question 8

Demand-pull inflation definition

Answer 8

> Inflation caused by an increase in demand when resources are scarce.
AD.

Question 9

Illustrating cost-push inflation

Answer 9

> Cost-push inflation can be illustrated by an inward shift of the AS curve.
Anything that increases the price of factor inputs will lead to cost push inflation.
Best illustrated on a classical diagram.

Question 10

Illustrating demand-pull inflation

Answer 10

> Demand-pull inflation is caused by an increase in AD.
In Keynesian diagrams, the extent to which we suffer from demand-pull inflation when there’s a rise in demand is dependent upon how close to full capacity the economy was when there was a shift in demand.

Question 11

What type of diagram do you use if question requires illustration of both types of inflation?

Answer 11

> Classical

Question 12

2 types of inflation

Answer 12

1. Cost-push inflation

2. Demand-pull inflation

Question 13

Consequence of inflation - list of 10

Answer 13

1. Fall in value of money.
2. Menu costs.
3. Shoeleather costs.
4. Administrative costs.
5. Inflationary noises.
6. Redistribution of income.
7. Fiscal drag.
8. Uncertainty.
9. Loss of international competitiveness.
10. Inflation causing inflation.

Question 14

Consequence of inflation - fall in value of money.

Answer 14

> With the price level rising, each pound will buy less. >The purchasing power of money falls.
Whether a household experiences a loss in purchasing power will depend on whether their disposable income rises by more or less than, or the same amount as, inflation.

Question 15

Consequence of inflation - menu costs

Answer 15

> the costs of changing prices due to inflation.
It is applied to the need for firms in general to alter their prices in, for instance, catalogues, newspaper advertisements and websites.
This involves time, effort and increased labour costs.

Question 16

Consequence of inflation - shoeleather costs

Answer 16

> costs in terms of the extra time and effort involved in reducing money holdings.
Relates to the costs involved in reducing holdings of cash and money in current accounts and seeking the highest rate of interest.
During periods of inflation, households and firms cannot afford to have money lying idle, not earning interest, as it will be losing value.
Therefore, they have to search out the most rewarding rate of interest.

Question 17

Consequence of inflation - administrative costs

Answer 17

> Staff time may have to be devoted to adjusting accounts, assessing raw material costs, negotiating with unions about wage rises and estimating appropriate prices.

Question 18

Consequence of inflation - inflationary noise

Answer 18

> The distortion of price signals caused by inflation.
It means that market prices do not signal the relative scarcity of products efficiently.
Without inflation, if the price of a product rose, it can be concluded that it has become relatively more expensive.
With inflation, however, consumers will be uncertain whether the rise in price does actually reflect a relative price rise or whether it is just in line with inflation.

Question 19

Consequence of inflation - redistribution of income

Answer 19

> Inflation can cause some people to gain and some people to lose in a way that is not based on economic or social merit.
For example, some workers with weak bargaining power may not receive wage rises which keep pace with inflation. Standard of living falls.
Borrowers will gain and lenders will lose if inflation reduces the real interest rate (the nominal interest rate minus the inflation rate).

Question 20

Consequence of inflation - fiscal drag

Answer 20

> People’s income being dragged into higher tax bands as a result of tax brackets not being adjusted in line with inflation.
Taxpayers will pay a higher proportion of their income in tax and so experience a fall in their disposable income.
The government will receive more tax revenue.

Question 21

Consequence of inflation - uncertainty

Answer 21

> If firms are uncertain about what their costs will be and what prices they will receive from selling their products, they may be reluctant to invest.
Inflation also complicates household financial planning, making it difficult for people to decide how much to save and where to place their savings.

Question 22

Consequence of inflation - loss of international competitiveness

Answer 22

> If the country’s inflation rate is above that of its main competitors, its goods and services will become less price competitive.
This is likely to result in fewer exports being sold.

Question 23

Consequence of inflation - inflation causing inflation

Answer 23

> If households expect prices to rise in the future, they may seek to buy more items now, thereby increasing AD.
If workers think that inflation may be a problem, they will ask for pay rises just to protect their current real earnings.
Inflationary expectations will also cause firms to raise their prices in order to protect their real profit levels

Question 24

Benefits of Inflation

Answer 24

> If it is a low and stable rate and is demand-pull inflation, then the higher AD and steady rise in price level may encourage firms to increase their output. (good if there’s a recession or slow growth).
Workers also like rises in their pay, even if these are matched by higher prices, with their real pay remaining the same. Psychologically, we like to feel that we are being appreciated and that our employers think we are doing well.
The ability that inflation gives firms to alter workers’ real pay can help labour markets to operate more efficiently and reduce unemployment. Workers usually resist cuts to their wages. If demand is falling, firms will have to cut their costs. Inflation enables firms to reduce their real wages. This can be achieved by either keeping wages the same or raising them by less than inflation. In the absence of inflation it is difficult to cut real wages, and firms might make some of their workers redundant in order to reduce their costs.

Question 25

What does inflation depend on?

Answer 25

> The rate of inflation - the higher it is, the more harmful.
The cause of inflation - cost-push tends to be more harmful because it is often accompanied by a fall in GDP and a rise in unemployment.
Whether inflation is fluctuating - makes it difficult to plan.
Whether inflation was correctly anticipated - anticipated inflation allows people to be more confident and measures can be taken to prevent the random redistribution of income.
Whether the inflation rate is relative to that of other countries.
What somebody spends their money on.
Where in the country someone lives.