Macro Objective 2: Inflation

Question 1

List five limitations of using the CPI to measure inflation.

Answer 1

1. groups earning different incomes consume different types of goods than those included in the basket, therefore CPI may not accurately reflect cost of living for all income groups
2. consumers change consumption patterns over time, due to changes in relative prices or preferences or the introduction of new products
3. CPI cannot account for improvements in product quality
4. CPI cannot account for regional price variation
5. CPI cannot account for effects of discounts and sales

Basket revised roughly every ten years, but even then is subject to the above limitations.

Question 2

What is the core/underlying rate of inflation and why is it used?

Answer 2

Rate of inflation excluding products with volatile prices e.g. food, oil. Large price fluctuations in these groups may give misleading impression about inflation trend.

Question 3

What is the producer price index and why is it used?

Answer 3

Measures change in average prices of factors of production. Measures price level changes at early stage in production, therefore is useful for predicting future inflation as measured by the CPI.

Question 4

What is the GDP deflator and how is different from the CPI?

Answer 4

Measure of average price level of all goods produced in an economy. Used to convert nominal GDP into real GDP.

Consists of prices of all goods and services produced domestically (including capital goods, government purchases and exports) while CPI focuses on goods purchased by domestic consumers (including imports).
Different uses: GDP deflator used to convert nominal to real GDP, CPI used to measure cost of living

Question 5

List three alternatives to using the CPI as a measure of inflation.

Answer 5

Core rate of inflation
Producer price index
GDP deflator

Question 6

Explain the redistribution effects caused by a high inflation rate, and explain ways they can be avoided.

Answer 6

losses for lenders, savers and receivers of fixed incomes (real value of money falls)
gains for borrowers and payers of fixed incomes (real value of payments falls)
some losses and gains can be avoided
a) pay lenders and savers at interest rate equal or higher to rate of inflation
b) increase income by rate equal or higher to rate of inflation

Question 7

Explain the redistribution effects caused by deflation.

Answer 7

gains for lenders, savers and receivers of fixed incomes (real value of money rises)
losses for borrowers and payers of fixed incomes (real value of payments rise)

Question 8

Define inflation.

Answer 8

A sustained and general increase in average price level over a period of time in a country.

Question 9

Define deflation.

Answer 9

A sustained and general decrease in average price level over a period of time in a country.

Question 10

Define disinflation.

Answer 10

A decrease in the rate of inflation.

Question 11

List and explain eight consequences of a high inflation rate.

Answer 11

R PIES MIX

1. redistribution effects
2. inability to predict future prices creates uncertainty among firms who can no longer accurately estimate future revenues and costs, negative effect on investment and economic growth
3. increased income inequality: as asset prices rise (real estate, gold), wealthy are in better position to invest and gain wealth compared to low-income groups
4. efficiency losses: price mechanism unable to fulfil signalling and incentive functions effectively
5. reduced incentive to save as people face loss on savings (if interest rate is low)
6. menu costs: incurs costs to firms for reprinting menus and price listings
7. X damages export competitiveness: exports become expensive to foreigners and fall, imports become cheaper for domestic consumers and rise, (X-M) falls and AD falls, GDP falls (furthermore: creates trade deficit, downward pressure on currency)
8. I money illusion: when people feel “richer” if their nominal incomes rise even through average price levels have increased at the same rate or higher. dangerous because people are compelled to increase their spending even though their real income has actually remained the same or even fallen

Question 12

Why does deflation only occur infrequently?

Answer 12

Wages do not fall easily*, making it difficult for firms to lower prices (see ratchet effect: AD falls but PL does not)
Oligopolistic firms are reluctant to lower prices as they fear price wars
In general, firms avoid lowering prices as this lowers their profits
*due to labour market rigidities, such as union power and minimum wage law

Question 13

List and explain six consequences of deflation. Why is it worse than inflation?

Answer 13

CUS DR. PMX
1. cyclical unemployment and deflationary spiral: as price levels fall, firms avoid spending as they wait for prices to fall further
price level falls –> spending postponed –> AD falls –> price level falls further –> spending further postponed etc.
(show monetarist diagram with falling AD)
deepens recession and cyclical unemployment
2. real value of debt rises, harder for borrowers to repay loans, more bankruptcies and risk of financial crisis (worse than inflation)
3. redistribution effects
4. inability to predict future prices creates uncertainty among firms who can no longer accurately estimate future revenues and costs, negative effect on investment and economic growth
5. menu costs: incurs costs to firms for reprinting menus and price listings
6. improved export competitiveness: lower export prices make them more attractive to foreigners, (X-M) rises and AD rises, GDP rises

Question 14

Briefly state the policies required to tackle inflation and deflation.

Answer 14

Inflation requires contractionary demand-side policies, or supply side policies. Deflation requires expansionary demand-side polices.

Question 15

Compare the use of fiscal policy and monetary policy to tackle demand-pull inflation.

Answer 15

fiscal policy: lower G and raise taxes

pro: lower G directly impacts economy, as G is component of AD
con: time delays, politically unpopular

monetary policy: raise interest rates, lower C and I
pro: quicker to implement, no political constraints (independent central bank)

note: supply side policies can also be used to tackle demand-pull inflation!

Question 16

Evaluate demand and supply side policies to deal with cost-push inflation.

Answer 16

contractionary demand side: lower inflation but deepen recession
supply side policies: better but large time lags. appropriate policy depends on cause of increased costs.
- rising wages: labour market reforms (reduce union power, lower minimum wage, reduce worker compensation, reduce unemployment benefits (raise S of labour and lower wages), evaluate these in SSP
- excessive monopoly power where firms are setting high prices for their goods e.g. OPEC - decrease monopoly power of firms through competition policy - privatisation, deregulation, trade liberalisation, evaluate these in SSP
- depreciating currency (higher import prices) - reduce dependence on imports (trade protection)
- increase oil prices - reduce oil dependence (incentive to use renewable resources e.g. carbon tax?)

Question 17

Evaluate the use of supply side policies to tackle inflation in general.

Answer 17

pro:
rise in LRAS reduces inflationary pressures whether AD remains constant or increases, LR economic growth
con:
very long time lags
ambiguous effect on unemployment - privatisation (lay off workers, cost-saving) vs lower UB which raises employment
may increase income inequalities and poverty - all labour market reforms except UB reduce labour costs

Question 18

Revise relationship between unemployment and inflation (Phillips curve), see mind-maps.

Answer 18

See mind-maps.