3.2 Inflation

Inflation

Sustained increase in general price level

Deflation

Sustained decrease in general price level

Disinflation

When inflation occurs at a lower rate. Prices are still increasing, but at a slower rate

CPI

Measures cost of living for typical households, comparing value of a ‘basket of goods+services‘ from 1 year to the base year.

Inflation Rate

Change in CPI divided by initial CPI

Limitations of Inflation Rate

• CPI may not entirely reflect consumption patterns of households

  • Cannot account for discounts sales

  • Cannot account for new products/substitutes

Cost Push Inflation

Caused by increase in COP, cuasing a fall in AS (aka Stagflation)

• Only occurs in Monetarist Model

Demand Pull Inflation

Caused by excess AD in the economy (inflationary gap)

Purchasing Power

Quantity of products which can be bought with money

Consequences of Inflation (FIREW)

1. Firms

   • Firms spend more money on menu costs

   • Firms may be cautious about making future investments due to fluctuating price levels

2. International Competitiveness

   • If domestic IR > foreign IR, our exports are relatively more expensive

3. Redistribution Effects

   • Pensioners, people on fixed wages lose out (typically low income households)

   • Hence government has to spend more $ on welfare for them

4. Effects on Economic Growth

   • (X-M) component

   • I component

5. Wage Price Spiral

   • Trade unions argue for higher wages for workers due to the higher cost of living

   • Firms comply, but their COP is higher, so they pass it on to consumers

   • Hence cost of living increases, spirals

Hyperinflation

When the price level increases by more than 50% per month

Deflationary Spiral

• AD Falls

  • So price level falls

• Firms lay off workers due to falling profits (from lower prices) + lower AD

• Unemployment rises, consumers have less disp. income, so AD. falls