price stability chapter 20 Flashcards
price stability
a low and stable inflation rate
inflation rate
the percentage rise in an economy’s price level over a period of time. it can be the change in average prices form one month to the next month, or from one quarter to the next quarter of the year
inflation
a sustained increase in an economy’s price level over a period of time. prices, on average, are rising at a particular rate
barter
direct exchange of goods and services for other goods and service
low and high inflation rates
low inflation rate is what governments want to experience stable inflation rate. high inflation rate cause price levels to increase at a significant percentage.
fluctuations in price levels
countries can experience large fluctuations in price level. at certain times, some countries experience a fall in their price level
price level
the average of all prices in an economy. when the price level increases the value of money falls and its purchasing power declines. each unit of the currency will buy less
creeping inflation
a low rate of inflation
hyperinflation
a very high of inflation, which may result in people losing confidence in the currency
creeping inflation
a low rate of inflation
hyperinflation
a very high rate of inflation, which may result in people losing confidence in the currency. considered to be an inflation rate that exceeds 50% a month. occurs when inflation goes out of control
what can firms do when there is a steady rise in prices
a low inflation rate can encourage firms to produce more
what does hyperinflation result in
results in people resorting to barter, exchanging goods and services for other goods and services instead of using money to buy and sell products
how to reverse hyperinflation
the currency has to be replaced by a new currency unit
deflation
a sustained fall in the price level. involve a negative inflation rate
disinflation
a fall in the inflation rate
what does deflation result in
it results in a rise in the value of money, with each currency unit having greater purchasing power
ways to compare inflation rate
the annual average method and year-on-year method
ways to compare inflation rate: the annual average method
a way of calculating the inflation rate by comparing the average level of prices during a twelve-month period with the average level in the previous twelve months.
ways to compare inflation rate: the year on year method
a way of calculating the inflation rate by comparing the percentage change in price level for a given month with that of the same month of the previous year.
consumer price index (CPI)
a measure that shows the average change in the prices of a representative basket of products purchased by households.
what does a country’s price indicate
A country’s price level indicates how much it costs to live in that country. A rise in the price level means that the cost of living has increased. To assess changes in the cost of living, governments construct a consumer price index (CPI).
how do governments construct a consumer price index
select a base year
carry out a survey to find people’s spending patterns
attach weights to the different categories
find out price changes
multiply weights by price changes
steps to constructing a CPI: select a base year
This is usually a year in which nothing unusual has occurred. The base year is given a value of 100. The base year is changed regularly.
steps to constructing a CPI: carry out a survey to find people’s spending patterns
A sample of households in the population are asked to keep a record of what they buy. The products purchased are placed into categories such as food and clothing and footwear.
steps to constructing a CPI: attach weights to the different categories
Weights are based on the proportion of total expenditure spent on the different categories. For instance, if on average households spend $500 of their total expenditure of $2000 on food, the category will be given a weight of 4 or 25%.
steps to constructing a CPI: find out price changes
Prices in a range of retail outlets and from a number of other sources such as gas companies and train companies are recorded.
steps to constructing a CPI: multiply weights by price changes
The total will give the change in the consumer price index.
problems in selecting a base year for the consumer price index
if a year is selected in which it is later found that inflation was unusually high, it may give the impression that subsequent percentage changes in the price level were unusually low
problems with carrying out a survey of peoples spending patterns: effect of people selected are representative of the whole population
the proportion of certain groups can be higher in the survey compared to the whole population which can lead to some goods have a weight that is disproportionately high because they have different spending patterns and so different inflation rates. even if the survey is representative, it does not mean that the inflation rate represents the price changes that each person experiences.
problems with carrying out a survey of peoples spending patterns: whether the people selected to keep details
The people who complete the survey may make mistakes in recording their spending or may deliberately leave items out. One item thought to be often under-recorded is spending on chocolate may be because people do not want other members of their family to know how much they are spending on a non-essential product or because claiming that they are trying to lose weight. they
baskets of goods and services
The basket is representative of consumer spending patterns, and the change in its price represents the rate of inflation faced by consumers as a whole.
problems with baskets of goods and services in CPI: becoming out of date
Most governments update the content of the basket regularly in an attempt to ensure that the weights remain representative of current household expenditure patterns. However, within the period before the updating, the basket remains fixed. Consumers may react during this time to changes in relative prices by altering their purchases.
problems with baskets of goods and services in CPI: different types of products
Most governments now assume in their measurement some substitution from one relatively expensive brand or type of product to another less expensive brand or type. However, governments do not allow for substitution between different types of products, As a result, the CPI does not fully reflect how consumers react to changes in relative prices.
problems with baskets of goods and services in CPI: new products
The basket takes time to include new products and to remove old products that are becoming less popular. Each year, only a small number of new products are included and old ones eliminated.
problems with baskets of goods and services in CPI: quality
they do not incorporate data on the change in quality of goods from period to period, as well as their nominal price
problems with baskets of goods and services in CPI: quality and size
while prices may not change, the quality and size of products may decline. Some governments seek to overcome the potential quality issue by putting a monetary value on the quality changes in products. If a product has improved or it has additional features, the value of the changes is removed from the price of the product. On the other hand, if a product has a diminished or removed feature, the value is added to the price. In practice, it can be difficult to estimate the value of quality changes.
money values
values at the prices operating at the time
real data
data adjusted for inflation
how is money values converted into real data
the figures are multiplied by the price index in the base year and divided by the price index in the current year
how can the changes in real data be estimated
estimated by deducting the change in the inflation rate from the change in the money value. For instance, if the money interest rate (sometimes known as the nominal interest rate) is 5% and the inflation rate is 6%, the real rate of interest is -1%.
causes of inflation
cost push inflation
demand pull inflation
causes of inflation: cost push inflation
inflation caused by increases in cost of production. increases can be because of an increase in costs or fall in value of exchange rate. an increase in a firm’s profit margins will also lead to higher costs of production. costs can also be pushed up by damage to or depletion of resources
causes of inflation: demand pull inflation
inflation caused by increases in aggregate demand not matched by equivalent increases in aggregate supply. results from an increase of any components of AD.
impact of the rise of AD
A rise in aggregate demand will have a greater impact on the price level the closer the economy comes to full capacity. An increase in some forms of government spending and investment may not be inflationary in the long run. This is because, for example, government spending on education may raise labour productivity and so increase productive capacity.
wage price spiral
higher wages causing prices to rise which, in turn, push up wages and so on
monetarists
economists who consider that inflation is caused by an excessive growth in the money supply. They suggest that if the money supply grows more rapidly than output, the greater supply of money will drive up the price level. Some economists view ‘monetary inflation’ as a specific cause of inflation.
arguments by Keynesians against monetarists
While all economists accept that there is a clear link between changes in the money supply and changes in the price level, there is a debate as to which causes which. Keynesians argue that it is inflation that causes an increase in the money supply and not the other way around. If costs rise, firms may borrow more from banks. This will cause an increase in the quantity of money.
how can changes both increase aggregate demand and increase cost of production
Some changes will both increase aggregate demand and increase costs of production. For example, a fall in a country’s foreign exchange rate may both raise the price of imported raw materials (cost-push inflation) and increase export revenue (demand-pull inflation).
what can inflation cause
there is a risk than an inflationary spiral may occur
how can inflationary spiral occur
Demand-pull and cost-push factors may interact and reinforce each other and an inflationary spiral may develop.
inflationary spiral
a continuous rise in prices that is sustained by the tendency of wage increases and cost increases to react on each other.
Higher government spending on state pensions, for instance, may increase aggregate demand. The resulting higher prices may encourage workers to call for higher wages. If they do gain higher wages, costs of production may increase, causing aggregate supply to decrease. The higher wages may increase consumer expenditure and so the upward pressure on prices would continue.
how is a reduction in net exports a cost of inflation
Inflation may reduce the international competitiveness of a country’s products and so increase import expenditure and lower export revenue. This may result in balance of payments problems.
how is an unplanned redistribution of income a cost of inflatio
Some people may gain and some people may lose as a result of inflation.
For instance, if the rate of interest does not rise in line with inflation, borrowers will gain and lenders will lose. This is because borrowers will pay back less in real terms and lenders will receive less. Savers will also lose out as the real value of their savings will fall.
how is menu costs a cost of inflation
Menu costs are the costs involved in changing prices. Menu costs affect firms, for example catalogues, price tags, bar codes and advertisements have to be changed. Changing prices involves staff time and is unpopular with customers.
how is shoe leather costs a cost of inflation
Shoe leather costs are the costs involved in moving money from one financial institution to another in search of the highest rate of interest.
how is fiscal drag a cost of inflation
people and firms are ‘dragged’ (pulled) into higher tax brackets. However, it can be argued that this is a cost of an inefficient tax system rather than a cost of inflation.
fiscal drag (bracket creep)
people and firms are ‘dragged’ (pulled) into higher tax brackets. However, it can be argued that this is a cost of an inefficient tax system rather than a cost of inflation.
how is discouragement of investment a cost of inflation
Unanticipated inflation can create uncertainty and so make it more difficult for firms to plan ahead. This may dissuade firms from investing, which will have an adverse effect on economic growth.
how is inflationary noise a cost of inflation
Inflationary noise can result in consumers and firms making the wrong decisions.
how is inflation causing inflation a cost of inflation
Inflation may generate further inflation as consumers, workers and firms will come to expect prices to rise. As a result, consumers, workers and firms may act in a way that will cause inflation. Inflationary expectations can be powerful and it can be difficult for a government to change such expectations.
inflationary noise (money illusion)
confusion over relative prices caused by inflation. A rise in the price of a product may not mean that it has become more expensive relative to other products; the product may have risen in price by less than inflation and so may have become cheaper in real terms.
how is inflation stimulating output a benefit of inflation
A low and stable inflation rate caused by increasing demand may make firms feel optimistic about the future. if prices rise by more than costs, profits will increase, which will provide funds for investment. Investment may also be encouraged as the real rate of interest may fall and consumer expenditure may rise as higher money incomes make people feel better off even if, in real terms, they are not.
how is burden of debt a benefit of inflation
Real interest rates may fall due to inflation or may even become negative. This is because money interest rates do not tend to rise in line with inflation. As a result, debt burdens may fall. A reduction in the debt burden may stimulate consumer expenditure which, in turn, could lead to higher output and employment.
how is preventing some unemployment a benefit of inflation
firms in difficulties may have to reduce their costs to survive. for many firms, wages form a significant proportion of their total costs. With zero inflation, firms may have to cut their labour force. However, inflation would enable them to reduce the real costs of labour by either keeping money wages constant or by not raising them in line with inflation. During inflation, workers with strong bargaining power are more likely to be able to resist cuts in their real wages than workers who lack bargaining power.
how does the cause of inflation affect inflation
Demand-pull inflation is likely to be less harmful than cost-push inflation. This is because demand-pull inflation is associated with rising output whereas cost-push inflation is associated with falling output.
how does the rate of inflation affect inflation
A high rate of inflation is likely to cause more damage than a low rate especially if the high rate develops into hyperinflation. Indeed, hyperinflation can lead to households and firms losing faith in the currency and may bring down a government.
how does the rate of inflation affect inflation
An accelerating inflation rate, and even a fluctuating (constantly changing) inflation rate, will cause uncertainty and may discourage firms from investing. The need to devote more time and effort to estimating future inflation rates will increase costs.
how does unanticipated inflation affect the rate of inflation
can also create uncertainty and so can discourage some consumer expenditure and investment. In contrast, if households, firms and the government have correctly anticipated inflation, they can take measures to adapt to it and so avoid some of its potentially harmful effects.
how does the inflation of other countries affect
How the inflation rate compares with the rate of other countries. It is possible for a country to have a relatively high rate of inflation, but if it is below that of competing countries its products may become more internationally competitive.
how does technology keep inflation rate low
These keep costs down and enable higher aggregate demand to be met by higher aggregate supply. Another reason is increased international competition.
how does the changes in labour market keep inflation rate low
These changes have reduced the ability of workers to call for wage rises.
result of inflation
the effects of deflation are largely influenced by the cause of deflation. Deflation will increase the burden of debt, may increase the real rate of interest and may result in menu costs.
how does good deflation occur
occurs as a result of an increase in aggregate supply.
how does bad deflation occur
it takes place when the price level is driven down by a fall in aggregate demand
results of bad deflation
output falls, which may result in higher unemployment. Consumers may delay their purchases, expecting prices to fall further in the future. Firms, seeing lower demand, may not invest and may reduce the number of workers they employ. Some debtors may get into difficulty and this may cause banks, in turn, to get into difficulty with the risk of some going out of business, losing their customers’ money. These effects will reduce demand further and economic activity will decline again.
debtors
people, firms or governments who owe money
reasons why government aims for a stable rate of inflation rather than a fall in the price level
Firstly, there is the belief that a low rate of demand-pull inflation may promote economic growth. Secondly, measures of inflation tend to overstate the inflation rate because they tend to take full account of quality improvements and the effect of consumers switching to lower-priced products.
