price level : inflation Flashcards
what is inflation?
Inflation is the sustained increase in the average price level of goods/services in an economy
what is deflation?
Deflation occurs when there is a fall in the average price level of goods/services in an economy
Deflation only occurs when the percentage change in prices falls below zero %
what is disinflation?
Disinflation occurs when the average price level increases but at a decreasing rate than before
what causes demand pull inflation?
Demand pull inflation is caused by excess demand in the economy
draw demand pull inflation diagram
diagram analysis
If any of the four components of AD increase, there will be a shift to the right of the AD curve from AD1 → AD2
At the original price (AP1), there is now a condition of excess demand in the economy (extend the dotted line across until it hits the new demand curve to identify the excess demand)
Prices for goods/services are bid up from AP1 → AP2
Demand pull inflation has occurred
If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms and consumers
This will result in an increase in consumption and investment
It is likely to lead to a form of demand-pull inflation
what causes cost push inflation?
Cost push inflation is caused by increases in the costs of production in an economy
draw cost push inflation diagram
diagram analysis
If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in productivity, there will be a shift to the left of the SRAS curve from SRAS1→SRAS2
At the original price (AP1), there is now a condition of excess demand in the economy
As prices rise, there is a contraction of AD and an extension of SRAS
Prices for goods/services are bid up from AP1→AP2
Cost push inflation has occurred
what do expectations refer to?
Expectations refer to individuals’ anticipations of future economic conditions
Often, if consumers expect prices to fall, they will delay purchases in the hope of purchasing good/services at lower prices
The delay in consumption then helps prices to fall!
Often, if consumers expect prices to rise, they will rush to purchase good/services at lower prices before they rise
The increase in consumption then helps prices to rise!
what does inflation psychology refer to?
Inflation psychology refers to the psychological factors that influence how individuals and businesses anticipate and react to inflation
what are the two types of inflation psychology ?
adaptive expectations
rational expectations
what does adaptive expectations mean?
Adaptive expectations assume that individuals base their expectations on past observations and experiences
If consumers / investors have experienced high inflation in the past, they may expect it to continue and adjust their behaviour accordingly. This can lead to persistent inflationary pressures
what does rational expectations mean?
Rational expectations assume that individuals form expectations based on all available information, including current and past data, and that these expectations are unbiased
Individuals are forward-looking and make decisions considering the most relevant and up-to-date information
what are the impacts of inflation on firms ?
Rapid price changes create uncertainty and delay investment
Price changes force firms to change their menu prices too and this can be expensive
what are the impacts of inflation on consumers ?
Decrease in purchasing power
Decrease in the real value of savings (as money will be worth less in real terms)
Fall in real income for those on fixed incomes or pensions
Inflation is more harmful to low income households
what are the impacts of inflation on government
Inflation erodes international competitiveness of export industries as the country’s exports are now relatively more expensive
Economic growth may slow due to a fall in exports and a possible fall in consumption
Trade-offs involved in tackling inflation, e.g reducing inflation may increase unemployment and/or reduce economic growth
