Unit 10.2+10.3 SL Flashcards
Define inflation
Inflation is the sustained increase in the general level of prices in an economy
Define Disinflation
Disinflation is the fall in the rate of inflation in an economy. This means the rate at which the general level of prices is increasing falls
Define Deflation
Deflation is the sustained decrease in the general level of prices in an economy
What is the index used to measure inflation
consumer price index (CPI)
What is CPI
CPI is a measure of the cost of living for the typical household, and compares the value of a basket of goods and services in one year with the value of the same basket in another yea. Inflation and deflation are measure as a percentage change in the value of the basket from one year to another. + = inflation. - = deflation
How to calculate % change in CPI
(New CPI - Old CPI)/old CPI) x100
Problems with CPI
Regional variation
Prices differ throughout the economy and so will inflation rates. Capital cities like Paris and Beijing will experience different inflation rates compared to provincial towns in those countries.
Change in the quality of goods
The quality of goods generally rises over time and this is not accounted for in the index. Computers are of better quality now than they were 5 years ago, but this will not necessarily be reflected in their price. This means inflation tends to overstate price increases because it does not allow for improvements in product quality.
One-off changes in price
Significant one-off changes in the price of a highly weighted good in the index can distort the inflation rate. A big increase in the price of petrol will cause a significant rise in the index although the price changes of other goods in the index may be relatively small. Economists try to factor this in by removing items with big, one-off price changes that distort the index. This is called the core or underlying rate of inflation.
What are the two types of causes of inflation
Demand-pull and cost push inflation
What is cost push inflation and how would it be shown on a diagram
Cost-push inflation occurs when there is a reduction in the short-run aggregate supply in the economy and the price level is pushed up by rising costs. Left shift in SRAS
What is demand-pull inflation and how would it be shown on a diagram
Demand-pull inflation occurs when a rise in aggregate demand in the economy causes (pulls) the price level in the economy to increase. Shift of AD to the right
What are the effects/costs of inflation
Redistribution effects:
Inflation redistributes income away from certain groups of people in the economy and towards other groups. Some gain purchasing power while some lose it.
Fixed incomes
Inflation has a negative effect on the disposable incomes of households whose wages cannot keep up with the increase in the average price level.
Borrowers and lenders
Inflation reduces the real value of repayments, leading to a redistribution of wealth from lenders to borrowers. Lenders can offset this by setting interest rates above inflation. Unexpected inflation spikes may hinder timely rate adjustments.
Investment
High inflation can lead to higher interest rates because lenders seek compensation for diminished purchasing power and central banks may raise rates to curb inflation. This increased cost of borrowing deters investment projects. Can shift AD to the left as investment is part of the AD nonprice determinants
Reduced international competitiveness
If a country’s inflation rate is higher than its main international competitors then the country’s firms will struggle to compete in international markets leading to a fall in exports and a rise in imports. Inflation will shift AD to the left anbd leads to fall in real GDP.
What is demand side deflation and how would it be shown on a diagram
Deflation can occur because of a fall in aggregate demand and this typically occurs in a recession. AD shift curve to the left
What is supply side deflation and how would it be shown on a diagram
Deflation that occurs on the supply side arises when the aggregate SRAS shifts to the right and leads to a higher output at lower prices
Consequences/cost of deflation
Deferred consumption: means consumers postpone consumption. Since value of goods and services decrease, they expect they will continue to fall, therefore it discourages spending and borrowing, thus business and consumer spending falls, thus AD falls further.
The rise in spending power
As the price of goods falls consumers can buy more with their income. This is the benefit of supply-side or good deflation.
International competitiveness
If one country’s goods are falling in price relative to their trading partners, then this could increase that country’s competitive advantage in international markets. Increase net exports lead to shift right AD
Reduced growth and recession
If deflation is caused by falling aggregate demand, then it can lead to falling or even negative economic growth and rising unemployment. These are the negative consequences of a deflationary gap and they are often associated with a serious recession.
Conflict between low unemployment and low inflation
When aggregate demand increases the national income rises from Y to Y1 and this is normally associated with a fall in unemployment. But the increase in aggregate demand will also lead to a rise in the average price level from P to P1 and an increase in the rate of inflation. The opposite occurs if aggregate demand falls leading to a fall in inflation but a rise in unemployment as national income falls. (Talk about demand deficient employment like cyclical)
