4.2.3.3 - Inflation and Deflation

Inflation

A persistent rise in the average price level

Deflation

A persistent fall in the average price level

Disinflation

Where the rate of inflation is falling, but is still positive

Consumer Price Index (CPI)

- Official measure used to calculate the rate of consumer price inflation in UK

- Calculates avg PL increase of a basket of around 700 different consumer goods and services

- Measures changes in the average cost of living

Target Inflation Rate in UK

2% +/- 1%

Who is responsible for achieving inflation target in UK?

Bank of England

Demand-Pull Inflation

A rise in the average price level caused by an increase in aggregate demand. (AD right)

Cost-Push Inflation

A rise in the average price level caused by an increase in the costs of production. (SRAS left)

Why does an Increase in AD lead to Demand-Pull Inflation (Chain of Analysis)

- Higher AD (shift right)

- Consumers more w&a to buy at any given price level

- Increased Output

- Too much demand chasing too few goods

- Demand-pull inflation

+

- As economy nears productive potential, more inefficient factors of production are used & factors of production become scarcer

- Cost of production rises

- More goods being produced but at higher cost per input

- Suppliers only willing & able to produce at higher prices

- Price level rises

- When productive potential is reached, additional AD results in no more additional output but simply 'deflects' into a higher price level

Why does an Increase in CoP lead to Cost Push Inflation (Chain of Analysis)

- Rise in commodities(oil)/wages/ fall in exchange rates(imports)

- Increased costs of production

- Producers are less willing & able to supply at any given price level in an economy

- SRAS shifts left

- Disequilibrium occurs, so contraction of AD to form new equilibrium

- At new equilibrium, avg price level increases

Quantity Theory of Money

Theory that assumes inflation is caused by a prior increase in money supply

Fisher's Equation of Exchange

MV = PQ

Money Supply x Velocity of Circulation of Money = Price Level x Quantity of Real Output in economy

PQ is Nominal GDP

Velocity of Circulation of Money

The speed at which money circulates round the economy where money is spent

Monetarist Model Argument

If the government creates an expansion of the money supply greater than the increase in real national output, households and firms hold excess money balances which when spent, increase the average price level (inflation)

- "too much money chasing too few goods" - excess demand - demand-pull inflation

Effects of Expectations of Workers on Inflation

If workers & unions expect inflation to be high they will...

Demand higher wages --> increase in CoP --> Firms raise prices --> Cost-push inflation

Effects of Expectations of Firms on Inflation

If firms expect inflation to be high they will...

- Expect CoP to rise --> Raise prices --> Cost-push inflation

- Will increase Investment now --> increase AD --> Demand-pull inflation

Effects of Expectations of Individuals on Inflation

If individuals expect inflation to be high they will...

Increase Consumption now --> increase AD --> Demand-pull inflation

Costs of Inflation

- Shoe Leather Costs = Time & effort to reduce money holdings from eroding due to inflation

- Inflationary Noise = Distortion of price signals caused by inflation (unsure whether price rise is because good has become relatively more expensive or is due to inflation)

- Menu Costs = Costs of changing prices in websites, catalogues, newspaper ads (time, effort, labour costs, costs of print)

*- Fall in the value of money = Purchasing power of money falls --> Standard of living falls (income & wealth effect means less consumption)

- Uncertainty = Firms uncertain about future costs and what prices they will receive for selling their products, so may be reluctant to invest. Households unsure how much to save and where to place savings.

- Random redistribution of income = Borrowers gain and savers lose because real value of money falls

- Fiscal Drag = Increase is nominal wage due to inflation causes people's incomes being dragged into higher tax bands as tax brackets not adjusted in line with inflation --> Real wage decreases.

- Administration Costs = Staff may need to devote time to adjusting accounts, assessing raw material costs, negotiating with unions about wage rises, estimating appropriate prices.

*- Loss of international competitiveness - Higher prices means g&s less price competitive --> Exports fall & Imports rise --> Current account deficit worsens

Hyperinflation Real Life Example

Zimbabwe November (2008) - annual rate of 89.7 sextillion percent

Benefits of Inflation

- Encourages Consumption & Investment =

- Encourages consumers to buy now before savings/income lose value --> Increases C --> Increases AD --> Stimulates SREG.

- Firms see rising demand --> Invest to fulfill demand for output --> Increase AD & LRAS --> Aids both SREG & LREG

- Avoid Real-Wage Unemployment = Inflation allows firms to more easily reduce workers' real wage without needing to decrease nominal wages --> Reduces real-wage unemployment

- Increasing Equality = Inflation redistributes wealth from savers to borrowers due to fall in real value of money --> May benefit low income households who need to borrow more - Equality is an objective of UK gov --> also leads to increased C --> Stimulate AD and EG

- Reduces Real Value of Government Debt = Fall in value of money --> Reduces real value of money gov owes --> Lowering burden and eases fiscal pressure

Evaluating the Consequences of Inflation (IDO's)

TWO VETS

T - Type of inflation - cost-push more harmful than demand-pull as accompanied by SREG

W - Who you are - Firms may benefit, Savers suffer more, Borrowers benefit, Different families have own personal inflation rates dependent on g&s they buy

O - Other countries' inflation - International competitiveness

V - Volatility of inflation - Higher volatility, worse impacts of inflationary noise, uncertainty, administration costs

E - Expected vs Unexpected - Unexpected is worse as more uncertainty & more likely fall in real wage rates

T - Time/Duration of inflation rate

S - Size of inflation rate - inflationary spiral

Good Deflation is caused by...

Improvements in the economy's supply side

Supply-side improvements/reduced commodity prices etc --> Reduced CoP --> SRAS (& LRAS) shifts right --> Fall in price level (deflation) --> Output/Real GDP & Employment rises

Bad Deflation is caused by...

Collapse in AD

Collapse of AD + Negative Multiplier Effect --> AD shift left --> Fall in price level (deflation) --> Output/Real GDP & Employment falls --> Deflationary spiral may result (multiple left shifts of AD)

Bad Deflation may cause a Deflationary Spiral as...

- If households believe prices are going to continue to fall, they postpone consumption --> C falls

- Falling employment --> Reduced incomes --> C falls

- Falling output --> Reduced business confident + Increased spare capacity --> Reduced incentive to invest --> I falls

- C & I falling --> AD falling --> Further deflation and reduction in output (negative EG) and unemployment increases further and deflationary spiral continues --> Economic performance suffers

When was the Great Depression of America

1929

Why was the Great Depression an example of Bad Deflation?

- Stock market crash caused panic and people withdrawing from banks

- This led to bank failures due to weak banking institutions --> decreased Money Supply --> decrease in price levels

- This caused a deflationary spiral where people delayed consumption anticipating further falls in price --> Decrease in AD --> Fall in Output Real GDP --> Increased unemployment, job losses --> Further decreases in AD

Commodity Prices

Weighted index of various commodities globally (e.g. oil, gold copper)

Effect of Falling Commodity Prices on Commodity Importing Countries (UK) on Inflation and EG

- For a country that imports commodities like the UK, commodities are a cost of production

- Cheaper commodities = lower CoP

- Producers more willing and able to supply at any given price level so SRAS to the right

- Equilibrium price level falls (reduction in inflationary pressures / deflation or disinflation)

- Extension of AD (wealth, international trade, interest rate effects)

- Equilibrium real GDP rises (SREG)

Effect of Falling Commodity Prices on Commodity Producing Countries on Inflation and EG

- For a country that produces and exports commodities like China, commodities have a negative effect

- Commodity price falls --> commodity exported value decreases

- Exports decrease --> Net exports decrease --> AD shifts left

- Equilibrium price level falls (reduction in inflationary pressures / deflation or disinflation)

- Equilibrium real GDP falls (reduction in SREG)

How does ECONOMIC GROWTH in Other Economies affect UK Inflation

Economic Growth in OC --> Incomes in OC increase --> Increased demand for UK's Exports --> Net exports increase --> AD increases --> DEMAND-PULL inflation

Economic Growth in OC --> Rise in demand for commodities --> Rise in CoP for UK firms --> SRAS Left --> COST-PUSH inflation

Economic Growth in OC --> Emigration of Labour from UK --> Higher equilibrium wages --> Higher CoP for UK firms --> SRAS left --> COST-PUSH Inflation

How does REDUCTION OF TARIFFS in Other Economies affect UK Inflation

Reduction of tariffs in OC --> Lower price of UK exports in that OC --> Increased demand for UK exports --> Net exports increase --> AD increases --> DEMAND-PULL inflation

How does HIGH INFLATION in Other Economies affect UK Inflation

High inflation in OC --> UK exports become more internationally price competitive --> Increased demand for UK exports --> net exports increase --> AD increases --> DEMAND-PULL inflation

How does STRONG ECONOMIC PERFORMANCE in Other Economies affect UK Inflation

Strong economic performance in OCs --> higher profits for OC firms --> may have additional funds for FDI --> increased FDI into UK --> Increased Investment --> Increase AD --> DEMAND-PULL inflation

How does NATURAL DISASTERS/WARS in Other Economies affect UK Inflation

Natural disasters/wars --> Restriction of supply of products (e.g. oil) --> Rising price of products --> High CoP for UK firms --> COST-PUSH inflation

Real GDP =

Nominal GDP / Price Index (or GDP deflator)