4.2.3.3 - Inflation and deflation

What is inflation?

A general increase in price level over time

What is deflation?

Where the average price level in the economy falls. Negative inflation rate

What is disinflation?

Falling rate of inflation. Average price level is still rising but at a slower rate.

What is constant inflation?

When the price level is increasing at the same rate for a period of time

What is accelerating inflation?

Price level is increasing at a higher rate in a time period.

How is inflation measured?

CPI (consumer price index) and RPI (retail price index)

What are the types of inflation?

Cost push inflation
Demand pull inflation

What is cost-push inflation?

Inflation which is caused by rising costs of inputs to production which are passed onto consumers in the form of higher prices.

How can increasing labour costs lead to inflation?

If wages make up a significant amount of a firm's totals costs then it may lead to an increase in prices. --> Firms would want to protect their profits so they will push increased costs onto consumer

What is the wage price spiral?

The process by which rising wages cause higher prices, and higher prices cause higher wages.
Firms expect inflation to rise they may increase prices to protect profits

How can rising import costs cause cost push inflation

Increase in import costs due to tariffs will lead to increase in price level.

How can an increase in indirect taxes lead to cost push inflation?

Increase in tax will be pushed onto consumers if the good is an inelastic such as addictive demerit goods leading to higher prices

What is demand pull inflation?

When demand outpaces the economy's ability to produce goods & services.

What causes demand pull inflation?

A depreciation in exchange rate
Lower taxes
Lower interest rates
Increased growth in export industries

How can a depreciation in exchange rates lead to demand pull inflation?

Causes imports to become more expensive as you buy less with the pound and exports to become cheaper. This increases AD

What are causes of cost push inflation?

Increase in wages
Expectations of inflation
Increase in indirect taxes
Depreciation in exchange rate
Monopolies

What are the effects of inflation on consumers?

Those on low and fixed incomes are hit the hardest by inflation, due to its regressive effect --> cost of necessities becomes expensive. The purchasing power of money fall
Real value of debt decreases --> If consumers have loans, the value of the repayment will be lower --> amount owed does not increase with inflation

What are the effects of inflation on firms?

High inflation --> high interest rates → cost of investing is high --> firms save --> This is a leakage
May become less price competitive on a global scale if inflation is high (dependent on other countries)
Unpredictable inflation will reduce firms confidence --> unaware of what their costs will be --> less investment

What are the effects of inflation on government?

The government will have to increase the value of the state pension and welfare payments, because the cost of living is increasing.

What are the effects of inflation on workers?

- Real incomes fall with inflation, so workers will have less disposable income.
- If firms face higher costs, there could be more redundancies when firms try and cut their costs.

What are the types of deflation

Malign, Benign

What is benign deflation?

Deflation caused by an increase in SRAS.
May be due to a decrease in the cost of production. Firms can supply more at a given price level

What is malign deflation?

Demand side caused by reduction in consumption due to low levels of confidence often a sign of a recession.

What is a deflationary spiral?

Prices fall, so people delay consumption as they expect their money will have more purchasing power tomorrow, so AD falls, causing prices to fall.

What are the consequences of deflation?

Holding back on spending
The real value of debt rises with deflation
lower profit margins (may lead to increased unemployment)
lower confidence and increased saving

What is the monetarists view of inflation?

Caused by too much money chasing too few goods

What is the fish equation of exchange?

Money supply Velocity of circulation = price level transactions

MV =PT

What is MV in the fisher equation?

Total spending in the economy

What is PT in the fisher equation?

Total output in the economy

What is the quantity theory of money?

States that there is inflation if the money supply increases at a faster rate than national income

What is assumed by the fisher equation

velocity and transactions is constant

What does the fisher equation show?

That increasing the money supply causes inflation as consumers have more money to spend. Shifting AD to the right --> firms increase supply creating a positive output gap --> this is inflationary

What are criticisms of the fisher equation?

V & T are volatile as it can change due to changes in people's behaviour in handling their money.
There may be spare capacity --> spare capacity means that increases in AD will help get unemployed resources used in the general economy.
There may be a liquidity trap - interest rates can fall to zero, but people may still save, so an increase in the money supply might not affect inflation

What does the impact of inflation depend on?

Whether the inflation was anticipated

What are benefits of low and stable inflation

Generates healthy consumption habits
enables adjustments of wages
Incentivises investment and production
Avoid risk of deflation
Avoid risk of high inflation

What are limitations of CPI

Not fully representative (represents expenditure of average household)
Different groups have different spending patterns
The CPI does not take into account the quality of goods (increase in price may also be paired with increased quality)
CPI is slow to incorporate new products