11.3 - Inflation and deflation

What is inflation?

The sustained rise in the general price level over time. This means that the cost of living increases and the purchasing power of money decreases.

What is deflation?

Where the average price level in the economy falls. There is a negative inflation rate.

What is disinflation?

The falling rate of inflation. This is when the average price level is still rising, but to a slower extent. This means goods and services are relatively cheaper now than a year ago, and the purchasing power of money has increased.

What is demand pull inflation?

When aggregate demand is growing unsustainably, there is pressure on resources. Producers increase their prices and earn more profits. It usually occurs when resources are fully employed.

What are the main triggers of demand pull inflation?

A depreciation in the exchange rate, which causes imports to become more expensive, whilst exports become cheaper. This causes AD to rise.

Fiscal stimulus in the form of lower taxes or more government spending. This means consumers have more disposable income, so consumer spending increases.

Lower interest rates makes saving less attractive and borrowing more attractive, so consumer spending increases.

High growth in UK export markets means UK exports increase and AD increases.

What is cost push inflation?

A rise in the general price level resulting from an increase in the cost of production

What are the main triggers of cost push inflation?

Changes in world commodity prices can affect domestic inflation. For example, raw materials might become more expensive if oil prices rise. This increases costs of production.

Labour becomes more expensive. This could be through trade unions, for example.

Expectations of inflation- if consumers expect prices to rise, they may ask for higher wages to make up for this, and this could trigger more inflation.

Indirect taxes could increase the cost of goods such as cigarettes or fuel, if producers choose to pass the costs onto the consumer.

Depreciation in the exchange rate, which causes imports to become more expensive and pushes up the price of raw materials.

Monopolies, using their dominant market position to exploit consumers with high prices.

What are the effects of inflation on consumers?

Those on low and fixed incomes are hit hardest by inflation. The purchasing power of money falls, which affects those with high incomes the least.

If consumers have loans, the value of the repayment will be lower, because the amount owed does not increase with inflation, so the real value of debt decreases.

What are the effects of inflation on firms?

Low interest rates means borrowing and investing is more attractive than saving profits.

Workers might demand higher wages, which could increase the costs of production for firms.

Firms may be less price competitive on a global scale if inflation is high. This depends on what happens in other countries, though.

Unpredictable inflation will reduce business confidence, since they are not aware of what their costs will be. This could mean there is less investment.

What are the effects of inflation on the 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 effects of deflation on the economy?

Deflation discourages spending because it makes goods and services cheaper in the future.

This can result in economic decline and increasing rates of unemployment. Deflation can worsen the effects of economic stagnation.

Deflation makes the real value of debt higher.

Since consumers have less disposable income, the level of spending in the economy falls, which worsens the effects of a recession.

There could be even lower growth and worse rates of unemployment if the real interest rate increases. If the interest rate is 0% and the deflation rate is 5%, the real interest rate is 5%. This means that saving is encouraged, because the rate of return is higher.

What is the Quantity Theory of money?

The Quantity Theory of Money states that there is inflation if the money supply increases at a faster rate than national income.