Topic 3.3 Inflation and Deflation Flashcards
Inflation
Inflation is the persistent/sustained rise in the general price level over time.
Deflation
The opposite of inflation, where the average price level falls over time.
Disinflation
Disinflation is the falling rate of inflation. This is where the general price level is still rising but to a lower extent.
CPI
Consumer Price Index
- A Family Expenditure Survey is carried out which collects information for a ‘consumer basket’ of most popular goods/services attached with the average prices
- These are weighted based on the % of income households spend on the good/service.
CPI disadvantages
- Personal inflation rates differ
- Price fluctuations of certain goods (food/energy) just means those prices have increased rather than inflation as a whole.
- It doesn’t involve housing costs
RPI
Retail Price Index
This is an alternative measure of inflation which works the same as CPI but involves housing costs.
Weighted index number formula
(sum of weight x price index) / sum of weight
Index number (formula)
(Raw number/base year raw number) x 100
% change formula
(new - old)/old x 100
Inflation consequences (2)
The cost of living increases
The purchasing power of money decreases
Depreciation of the exchange rate
2 causes of inflation
Demand-pull inflation
Cost-push inflation
Demand-pull inflation
This is when AD (aggregate demand) increases and shifts to the right. These are due to demand-side shocks to the economy such as:
- depreciation in the exchange rates (much cheaper exports and expensive imports)
- Fiscal stimulus
- Very low interest rates
Policies to reduce demand-pull inflation
Contractionary monetary policy
Cost-push inflation
This is when AS (aggregate supply) decreases and shifts to the right. These are due to supply-side shocks:
- depreciation of exchange rates (less cheap labour, therefore an increase in costs of production)
- Changes in world commodity prices
- Indirect taxes
Policies to reduce cost-push inflation
There isn’t really any. You can’t control an increase in raw material prices, for example. However, they are short-term so they will likely fix themeselves.
Policies to reduce long-term inflation
Supply-side policies to shift LRAS right
This is due to the economy having very low levels of spare capacity meaning you can get consistently high rates of inflation
How does inflation impact purchasing power.
If there is inflation, then this decreases purchasing power. This is because assuming wages and income aren’t rising in line with inflation, then in real terms households are worse off as the general price level has increased for everything whilst their wages are the same. This can increase inequality/poverty. Same concept for things like savings
Price Wage Spiral
This is where workers demand higher pay in order to allign with inflation rates. So when firms agree to pay this, then their costs of production increase, which causes cost-push inflation.
Consumer Price Spiral
Similar to wage price spiral, if consumers predict an increase in inflation in the future, they will buy more now. But if everyone does that = demand-pull inflation.
Fiscal drag
During a time of inflation, if workers are being paid to be alligned with the rate of inflation, then they aren’t any better off. However, this can drag workers into higher tax bands therefore they have to pay more tax which lowers standards of living.
Costs of inflation
1) Loss of purchasing power (can affect living standards)
2) Erosion of savings (become less valuable in real terms)
3) Lower export competitiveness (exchange rates)
4) Wage/Consumer Price Spiral
5) Fiscal drag
6) Inflationary noise (signalling of price mechanism insignificant if prices are up, down - volatile. Leads to uncertainty so less C + I)
Benefits of inflation
1) workers with higher wages (productivity)
2) consumption is natural
3) firms encouraged to invest/increase output
4) Can keep unemployment low during a recession - keeping skilled workers
5) reduces real value of debt
6) Improvement if govt finances
Evaluation of inflation
Depends on
1) Rate
2) Cause - demand-pull> as it means short-run economic growth. More controllable and can use fiscal/monetary policy. Cost-push can lead to stagnant economic growth and is difficult to control.
3) Duration
4) Anticipated vs Unanticipated. Anticipated worse as it risks consumer/wage price spirals but unanticipated doesn’t.
5) Stability - less volatility is much better.
2 causes of deflation
Demand-side deflation (Bad/Malignant Deflation)
Supply-side deflation (Good/Benign Deflation)
Demand side deflation
This is where AD shifts to the left. This comes with lower growth - less RNO. They are assumed to be long-term (as could lead to recessions which are long-term) and thus anticipated (spirals).
Supply side deflation
This is where SRAS shifts to the right. This comes with greater real national output thus, higher short-term economic growth. This is likely to be short-term (raw material prices may have decreased but can very well increase), which means that it is unanticipated (doesn’t lead to consumer/wage price spirals).
Anticipated deflation
These lead to deflationary spirals
1) Delayed spending - as consumers believe that there will be cheaper prices. Causes demand shift to left, lower prices, contraction in supply, unemployment etc.
2) Increases real value of debt - incentive to save.
Unanticipated deflation
Usually short-term
1) Falling prices for consumers
2) Buy cheaper raw materials
Evaluation on deflation
1) Whether it’s anticipated or unanticipated. 2) Cause (less demand or cheaper raw materials).
