Price Stability Flashcards
Inflation
A situation where the economy faces a sustained increase in the general price level of goods and services.
Inflation rate
The rate of change of the general price level, and is calculated as the percentage change in the consumer price index.
(CPI current year - CPI year before) divided by CPI year before
Demand pull inflation
This inflation is caused by rising AD in an economy that is operating near or at full employment of resources, where there is a persistent increase in AD but little or no increase in AS such that prices are pulled upwards.
The nearer the country is to full employment, the harder it will for firms to increase their output of goods and services due to a shortage of resources. Hence, the excess demand will only result in a greater rise in general price level.
Cost Push inflation
This inflation is caused by rising costs of production such as rising wages, oil or other commodity prices such as food crops, iron ore and steel. It is inflation arising from the supply side of the economy.
This is especially so for countries which imports a significant amount of their FOPs, costs of production rises due to increase in price of imported intermediate goods. Which can be due to a depreciation of local currency which raises the domestic price of imports.
Wage push inflation may also be a reason, where firms face a rise in cost of production due to increase in wages and respond by raising the prices of goods and passing the increase to Households. With the increase in prices, trade unions may demand further wage increases in order to maintain the real income of workers and thus leading to further increase in COP and further inflation.
Advantages of mild inflation
Mild inflation is a low level of inflation such that profit maximising producers are incentivised to increase production and therefore investment expenditure which causes a rise in AD. Unplanned stock depletion then occurs and triggers a multiplied increase in real GDP. Derived demand for labour increases, causing a fall in demand-deficient unemployment.
Consequences of internal inflation
a) Economic Growth: If inflation is cost push in nature, increased COP will cause producers to cut production, thereby leading to a fall in real GDP, causing a fall in actual growth.
If inflation is severe, it will cause increased speculation and uncertainty over the economy. Firms find it difficult to make accurate projections on rate of returns and thus discouraging investment. I falls and thus AD falls, causing a multiplied fall in real gdp and fall in actual growth. Fall in I also causes fall in productive capacity, affecting potential growth.
b) Inefficient allocation of resources due to Shoe Leather costs and Menu Costs: As severe inflation occurs, people increase the search time to discover more about prices to manage their money and other assets, rather than using those resources to produce goods and services. As a result, inflation increases the opportunity cost of holding money. Firms on the other hand may face a fall in profits, this is because they have to constantly change their bulky catalogues to send price information to customers thereby driving up their costs of production. Overall, both leading to inefficient allocation of resources in the economy as resources are channeled away from productive activities.
Consequences of External Inflation
a) Impact on net exports: When price level in a country increases more than others, exports become expensive to foreign buyers, while imports become cheaper to domestic buyers. Country’s export competitiveness falls. Thus there is a fall in demand for country’s export and a rise in import expenditure. This causes a worsening of net exports X-M.
b) Impact on FDI and capital Inflows: Severe and unanticipated inflation also increases the costs and risk of investments in the country. Uncertainty of the expected rate of return from the investment in the economy will negatively affect investors’ confidence levels and choose to invest less. FDI will flow out of the country, reducing the level of capital stocks in the country.
Deflation
A situation where the economy faces a sustained decrease in the general price level of goods and services.
Causes of deflation
a) Persistent fall in AD, results in a surplus of foods and services, firms faces unplanned stock accumulation and lowers prices to clear excess stocks.
b) Rise in AS, due to a fall in COP or rise in productive capacity. Surplus causes a downwards pressure on prices of goods and services, thus firms reduce prices to clear the excess stocks.
Consequences of deflation
a) Cyclical fall in Economic Growth: Deflation follows when an economy experiences a recession. As prices fall, consumers and firms begin to hold money, and desire to save more in anticipation of further fall in prices. This leads to a further fall in C and I, and hence AD, as well as prices employment and growth. Falling prices reduces the profits of firms as well as expectations of future consumer demand and thus profitability. That reduces the incentive to invest in capital equipment causing the cycle to repeat itself.
b) Debt and Borrowing: When there is deflation, real interest rates increase and real cost of borrowing rise. This increase in real interest rates will weaken AD further due to a fall in C and I, putting downward pressure on prices. As real value of debt rises, consumers and firms have to spend a bigger percentage of the real disposable income to meet debt repayments. Thus, higher real debts can be a big drag on consumer confidence, causing consumption to fall further.
