3.4 - inflation, deflation, Philips curve

inflation

a sustained increase in the average prices of goods and services in the entire economy

deflation

a sustained decrease in the average prices of goods and services in the entire economy

disinflation

a decrease in the rate of inflation (eg. 10% → 7%)

consumer price index

• index of prices of the costs of living for a typical household

• compares the value of a basket of goods and services in one year with the value of same basket in base year

• CPI for a base year is always 100

formula for CPI for a specific year

CPI for a specific year = (value of basket in specific year / value of basket in base year) x 100

real income formula in relation to CPI

real income = (nominal income / CPI) x 100

problems with CPI (overstating degree of inflation)

• different rates of inflation for different income earners

  • CPI reflects average prices

• different rates of inflation depending on regional or cultural factors

• changes in consumption patterns

  • due to more sales and discounts

  • due to consumer substitution when relative price changes

  • new products

• changes in product quality

  • CPI doesn’t account

core rate of inflation

excludes volatile items such as food and energy prices to provide a clearer view of long-term inflation trends.

types of inflation

• demand-pull inflation

• cost-push inflation

demand-pull inflation

• increase in AD

• real GDP>potential GDP

  • inflationary gap

• unemployment <natural rate of unemployment

• demand is so large the unemployment temporarily find jobs

cost-push inflation

• fall in SRAS, due to increased costs of production/ supply-side shocks

• real GDP < potential GDP

  • although indicates recession, its NOT called recessionary gap

    • STAGFLATION

purchasing power

quantity of goods and services that can be bough with money

• decreases with inflation

• increases with deflation.

%change in pp = %change in nominal income - %change in price level

price level ↑ = purchasing power↓

costs of inflation

• redistribution effects

• uncertainty

  • fewer investments

• effects on savings

  • lowered incentive to save

• international export competitiveness

• negative effect on economic growth

  • inflation = lower AD = lower economic growth

• social and personal costs are unequally distributed

redistribution effect definition

inflation redistributes income away from certain groups of economy to other

redistribution effect: groups who lose from inflation (real value ↑)

• people with fixed incomes/wages

• people who receive incomes/ wages that increase less rapidly than rate of inflation

• holders of cash

• savers

• creditors (when lending interest rate < rate of inflation)

redistribution effect: groups who gain from inflation (real value ↓)

• borrowers (because the real value of their debt decreases)

• payers of fixed incomes/ wages

• payers of incomes/ wages that increase less rapidly than rate of inflation

cost of inflation: international export competitiveness

• decline in international export competitiveness

  • as domestic goods become more expensive compared to foreign goods, potentially reducing demand for exports.

hyperinflation

a rapidly accelerating inflation rate, typically exceeding 50% per month

• due to significant increases in the supply of money

  • governments printing money

consequences of hyperinflation

• inflationary spiral

inflationary spiral

(money value ↓↓ = consumer spending ↑ = feeding AD = demand-pull inflation = worker demand for higher wages ↑= cost-push inflation = ….)

• businesses stop investing

• businesses withold goods from sale

• creditors suffer massive losses as real value of debts falls dramatically

• money loses value all together

deflation

• due to fall in AD

• due to increase in SRAS

costs of deflation

• redistribution effect

• increase in purchasing power

• deffered consumption

  • deflationary spiral

• risk of bankruptcies

• inefficient resource allocation

  • increased unemployment

  • economic stagnation

• policy ineffectiveness

  • central banks struggle to stimulate the economy due to lower interest rates.

redistribution effect: groups who gain from deflation (real value ↑)

• individuals on fixed incomes/wages

• holders of cash

• creditors

redistribution effect: groups who lose from deflation (real value ↓ )

• borrowers

• payers of fixed incomes/wages

deflationary gap

(…. real value ↓ = AD↓ = rGDP ↓= cyclical unemployment ↑ = AD ↓↓= real value ↓ ….)

• consumers and businesses anticipate falling prices, leading to decreased demand for goods and services

  • further economic contraction

Phillips curve in short run (monetarist and keynesian)

illustrates the inverse relationship between inflation and unemployment rates

reasoning behind the movement along SRPC

Philips curve in long run Monetarist and Keynesian

reasoning behind shifting SRPC in long term