Book 10A - Causes of inflation

Define inflation, GPL, inflation rate

• Inflation (Def.): Inflation is a situation where there is a sustained increase in the general price level of an economy

  • NOTE: Inflation is NOT increase in prices of certain items only due to temporary increase in demand 

• GPL (Def.): average price of all G&S in the economy during a period of time

• Inflation rate (Def.): Rate of change of GPL

State internal VS external value of money

• GPL and the real value of money are inversely related

• Internal value of money: domestic PP 

• External value of money: foreign exchange rate

Define and describe CPI

• CPI (Def.): changes in the price of a fixed basket of G&S commonly purchased by the average household over time, with respect to a selected base year

• Do NOT measure price changes of goods bought by firms, government, foreigners 

• Price of CPI basket in base year is 100

Define stagflation, deflation, disinflation

• Stagflation (Def.): A situation of high unemployment and rapid inflation with negligible growth in national output or even contraction of the national output

• Deflation (Def.): A sustained decrease in the general price level of an economy

• Disinflation (Def.): A period where the inflation rate is still positive but declining over time

State and describe 4 degrees of inflation

1. Mild inflation

0% < IR < 3% per annum

• Price increasing at modest rate -> price stability 

2. Moderate inflation

IR 4-10% per annum

• Prices increasing at moderate rate -> fairly stable prices 

3. Galloping inflation

IR > 10% per annum

• Prices increasing at high rate 

• PP of money is eroding -> people store wealth in physical assets 

4. Hyperinflation

IR > 50% per month 

• Extremely large increases in prices 

State demand pull inflation graphical anal (from firms increase production)

• When firms increase output and operate closer to Yf, production becomes less efficient

• Firms will be forced to use resources that are less and less suitable for their production

• Increasingly larger amounts of labour and other inputs are required per additional unit of output produced -> UCOP increase

• Firms will only produce extra output if it can be sold at higher prices

• Rise in AD led to a rise in national output and GPL

• When AD rises further and with the increased scarcity of resources, the GPL is further pulled upwards with limited increase in national output

• Once Yf is reached, continued increases in AD will lead to increase in GPL only

Descirbe initial rate in AD wage push spiral

• Due to the rising GPL and cost of living, trade unions (workers) bargain for higher wages to preserve workers' purchasing power

• Higher wages leads to unit COP rising -> AS fall and GPL rise to P3

• Furthermore, expectations of higher inflation in future, which would cause a fall in the internal value of money, would result in households increasing their consumption in the current time period -> AD rises from AD2 to AD3, pushing prices up from P3 to P4

• This fuels further demand for increases in the wage and prices increase -> causing a wage-price spiral

Draw initial rate in AD wage push spiral GRAPH

What is demand-pull inflation caused by

1. Factors affecting rise in AD 

• Eval: SG context 

  • Due to the prompt and effective government response to the Covid- 19 pandemic domestically, households and firms in Singapore have regained expectations of strong future economic performance by 2022 

2. Country money supply 

• Money supply increase and excess money demand -> public will convert the excess money into physical assets by spending the excess money on G&S 

• Increase C and AD -> GPL increase as too much money chasing after too few G&S in the economy

Describe sustained rise in GPL by cost-push inflation via govenrment policy

• If fall in real GDP causes government to implement policies to boost AD, AD rises causing GPL to rise to P3 

• Due to the fall in real incomes which will decrease the purchasing power and standard of living of workers, trade unions might bargain for even higher wages without corresponding increases in labour productivity to preserve their PP -> UCOP rises even further -> exacerbating and causing a sustained rise in GPL to P4

Draw sustained rise in GPL by cost-push inflation via govenrment policy GRAPH

STATE what cost push inflation is caused by

1. Wage-push

2. Increase in price of imported inputs

3. Tax-push inflation

4. Ageing population

Explain how wage-push and increase in price of imported inputs causes cost push inflation

1. Wage-push 

• Aging population/government policies -> labour force declines 

• Trade unions push up wage rates independently of the demand for labour (labour strikes) 

• When wage rate rises faster than rise in labour productivity -> unit labour cost increase -> inflation 

2. Increase in price of imported inputs 

• Caused by: 

  • Cost of imported input increase (Imported inflation) caused by supply shocks 

  • Depreciation of the foreign exchange rate

State SG eval ageing population

1. Tax-push inflation (indirect taxes) 

2. Ageing population 

• Eval: SG context 

  • By 2030, it would be almost 1 in 4 Singaporeans over 66

  • These citizens who are aged 65 and older are more likely to be retired from the labour force

Explain how advent of vaccines AND cause inflation

1. Advent of vaccines = tourism 

• People can travel -> increase in national income in economics of trading partners -> increase PP -> X increase 

2. Driven by lower prices, rather than symptomatic of weakness in domestic economy = deflation NOT caused by fall in AD = no DD-side deflation 

What is headline inflation

Headline inflation = GPL of everything increase

What is Debt amplified your indebtedness

4. Debt amplified your indebtedness = real value of debt increases -> real IR increase -> discourage borrowing by firms and consumers -> C and I falls -> AD falls -> multiplier effect -> -ove AG 

• Fall in I also causes PC to fall -> -ve PEG

Explain why SG GPL is expected to rise in 2021 

1. Explain why SG GPL is expected to rise in 2021 

• 1 cost-push + 1 demand-pull reason 

• SG: do NOT use C/I on its own (SG main driver is (X-M), only use to supplement) 

Discuss whether deflation is always good for the economy 

1. Discuss whether deflation is always good for the economy 

• R1: SOL increase 

  • Cause of fall in GPL (oil price fall -> UCOP fall -> AS increase -> GPL fall) -> why SOL improve 

• R2: -ve EG

Explain why governments aim for low and stable inflation 

1. Explain why governments aim for low and stable inflation 

• R1 + 2: why low and stable inflation good OR 

• R1 + 2: why high inflation BAD (lowkey easier) 

• NOTE: For I, pick either MB or MC change (not both) + no need nmSOL (assume nmSOL constant) (only give in CSQ if got evidence) 

Extent of fall in SOL EVAL

1. Extent of fall in SOL 

• Depends on its duration and underlying cause

• Japan: prolonged deflation would be considered malignant, as it likely led to entrenched expectations of falling prices -> hh delay C and firms to reduce I

• This reinforced weakened AD, and led to a deflationary spiral -> negative income growth and increased the real debt burden -> worsening mSOL 

•  SG: Deflation is ST and supply-driven -> hh and firms are less likely to defer their C and I -> limiting the negative impact on SOL

Extent of complementary policies EVAL

1. Complementary policies 

• SG: mild and anticipated inflation is accompanied by wage adjustments and government transfers, which can help hh maintain their real incomes -> smaller impact

Is DD or SS-side deflation more harmful OVERALL eval

• DD-side deflation is typically more harmful as it reflects falling AD -> lower C and a potential deflationary spiral

• SS-side deflation driven by productivity gains may support growth as output and incomes rise

• In the case of inflation, inflation becomes more damaging when it is high and persistent -> erode real incomes significantly

• Prolonged deflation can entrench expectations and weaken demand 

• Most damaging outcomes arise from DD-led and prolonged deflation