4. Inflation and Deflation

What is Inflation

Inflation is the persistent increase of price in an economy in a year

Causes of Demand Pull Inflation

Lower Interest Rates

Lower Income/Corporation Tax

Increase in Consumer/Business Confidence

Increase in Government Spending

Weak Exchange Rate

Causes of Cost Push Inflation

Increase in Raw Material Prices

Increase in Wages

Increase in Business Taxes e.g. VAT

Increase in the price of imported raw materials due to a weaker exchange rate

Benefits of Inflation

Higher Wages

Consumption is Natural

Firms Encouraged to Increase Output

Can Keep Unemployment Low in a Recession

Reduces Real Value of Debt

Improvement of Government Finances

Costs of Inflation

Lower Purchasing Power

Erosion of Savings

Lower Export Competitiveness

Wage/Consumer Spirals

Fiscal Drag

Inflationary Noise

Evaluation of Inflation

Rate

Cause

Duration

Anticipated vs Unanticipated

Stability

Benefits of Supply Side Deflation (good deflation)

Higher Growth (AD will shift to the right long run)

Short Term and Unanticipated

Falling Prices for Consumers

Falling Input Prices for Firms

Costs of Demand Side Deflation (bad deflation)

Lower Growth (AD shifts left so unemployment)

Long Term and Anticipated

Delayed Spending

Positive Real Interest Rates

Increases Real Value of Debt

Evaluation of Deflation

Anticipated or Unanticipated

Cause

What is the Quantity Theory of Money

A theory that directly links money supply and the inflation rate

What is Fisher’s Equation

MV=PQ

M: Money Supply

V: Velocity of Circulation

P: Average Price Level (Inflation Rate)

Q: Quantity of Goods/Services Sold