inflation and deflation

The consumer prices Index (CPI)

measures the average basket of goods , preferred measure

the measure bank of england uses

the retail prices index (RPI)

average basket of goods + house prices

how is rate of inflation calculated ?

weights x price changes = the weighted price

annual percentage change in consumer prices.

limitations of CPI as a measure of inflation

time consuming to measure

small sample size

expensive to collect data (large opportunity cost)

CPI id not fully representative of spending matter and different demographics (no context)

CPI does not update quickly enough

Inflation

inflation is a sustained increase in the general price level, leading to a fall in the purchasing power of money

with the fall in the value of money, a fixed amount of money buys less than before (purchasing power fallen)

What does the Bank of England do?

It is the job of the Bank of England to set monetary policy and interests rates so that inflationary pressures are controllled and the inflation target is reached.

what is the inflation target set by the government?

2%

it is enough to encourage people to buy things but not too high to discourage consumption all together

what is expansionary monetary policy?

lowers interest rates which encourage spending

lowering the rate of return from saving so AD increases, increasing growth

what is contractionary monetary policy?

raises interest rates and encourages more saving,

meaning consumption falls, AD falls, and then growth falls.

who is in charge of monetary policies?

governor of The BoE

who is in charge of fiscal policies?

chancellor of the Exchequer

(taxation+spending)

what are the 2 types of inflation?

demand pull and cost push

What is demand-pull inflation?

demand-pull inflation is caused by excess aggregate (AD) (linked to money of credit boom)

occurs when the economy is close to capacity with inelastic aggregate supply (AS)

leads to a positive output gap (AD>potential GDP)

comes from demand side of economy

high demand-pull factors lead to high prices in growing economy

What is cost-push inflation?

caused by rising wage costs in the labour market

such as increasing raw material and component costs from domestic and overseas suppliers

rising import prices are due to a falling exchange rate which increases import costs.

comes from supply side of the economy

any rise in the costs of production is pushed onto consumers through higher prices

What causes inflation?

rising property prices - increased consumer wealth - demand-pull inflation risk

increasing world oil prices - higher costs for businesses - cost-push inflation risk

depreciating exchange rate - increased import prices + rising exports - demand pull+cost push inflation risk

rapid expansion of money and credit from banks - rising consumer spending financed by loans - risk for demand-pull inflation

Internal Factors

come within out economy and are controlled by government

surge in property prices

higher wages/labour costs

boom in credit/money supply

rise in business taxes

External Factors

come within other global economies

increase in world oil/gas prices

inflation in global commodity prices

depreciation of exchange rate

high inflation in other countries

Why is high inflation an economic problem?

Causes of inflation?

inequality- regressive effect on lower-income families; most of their wealth is stored in cash

falling in real incomes- if wage rises lag behind price increases each year

negative real interest rates- if the interest rates on savings is lower than inflation

cost of borrowing - higher interests rates for businesses and consumers with debts

risk of wage inflation - leads to rising labour costs and lower profits

effect on businesses

high relative rate reduces business competitiveness which lowers demand of the country's exports

high and volatile inflation is bad for confidence as businesses are not sure of what their costs are likely to be. may lead to a fall in capital investment

certainty is wanted otherwise they cant plan effectively and determine cash flow and revenue

inflation is difficult to forecast due to ?...

volatile global energy prices

changes in value of currency

uncertain growth of aggregate demand

volatile food prices

goverment indirect taxes can change

deflation

is a persistent fall in the general price level of good and services

demand side causes of deflation

fall in AD causing a persistant recession/depression

fall in money supply

increase savings

fiscal ausetirty

supply side causes of deflation

falling costs of production

significant fall in wage rates

external deflation

improved tech

consequences of price deflation

Holding back on spending consumers may postpone demand is prices to fall in the future

debt increase- the real value of debt rises with inflation and higher real debts can be a big drag on consumer confidence

confidence and saving falling asset prices such as price deflation in the housing market hits personal sector wealth and confidence

lower point margins lower prices can mean would no reduced revenues and profits for businesses this can lead to higher unemployment as as firms seek to reduce costs by shedding labour

price competitiveness if prices are low in a country this would increase exports as they are more competitive in the global marketplace

How to avoid deflation using macro stimulus policies

Low interest rates and quantitative easing- cheaper loans for businesses and households

expanding the supply of credit in banking system quantitative easing used by many central banks including Bank of England and European bank

fiscal stimulus measures- higher government spending a rising government borrowing to inject demand into the circular flow lower direct taxes to increase disposable income and spending

other measures to stimulate aggregate demand attempts to lower the value of the exchange rate higher taxes on savings to encourage consumption

disinflation

Disinflation is where prices are still increasing (positive inflation), but at a slower rate than before

Is disinflation good or bad?

if inflation is high disinflation is good

This is because we want to get inflation back to the target, so make it decrease toward 2%.

For example, if inflation was 8% and there was disinflation, and the new rate was 2%, this would be good

Is disinflation good or bad?efc

if inflation is low, disinflation may be bad

If the inflation rate was 1.5%, and disinflation happened making the rate fall to 0.2%, this would be bad, as the rate would be further from the target rateNote:The target inflation rate is 2%. If disinflation takes the inflation rate closer to this target it may be considered as a good thing

what does the phillips curve show?

the Phillips curve shows the trade-off between inflation and unemployment

shows that the government cannot have low and stable inflation at the same time as having low unemployment.

lower the unemployment frate the higher the inflation rate

what happens when unemployment is low?

And unemployment is very low there is not a lot of spare capacity they have to raise wages higher to incentivize

what does an increase in wage suggest about inflation?

As people earn higher wages it creates more demand for goods and services and this creates demand for inflation

to combat this the government may try to increase taxes or tell the monetary Policy Committee to increase interest rates to lower inflation but this comes at the expense of increasing unemployment, due to higher taxes discouraging spending in the economy

firms may have to start laying off excess staff due to lack of aggregate demand for their goods and services as workers are laid off income force and the cycle continues.

phillips curve diagram explanation in SR

In the short run if unemployment is low inflation is high

this is shown by a movement along the SRPC from A to B

as unemployment decreases from YFY - Y FE1 inflation increases from i - i2

When unemployment falls in the economy it gets closer to full employment

demand is continuously shifting to the right to reach a long term trend rate of growth

short 1 outcome is displayed as the movement along from A to B is from this is from an increase in aggregate demand which causes unemployment to fall and demand pull inflation to occur

phillips curve diagram explanation in LR

One point B to C (shift outwards) illustrates the economy returning to long run equilibrium this occurs because as inflation has increased workers supervise the wage expectations and ask for an increase resulting in a wage spiral

increase in cost LR

This increase in costs for farms causes aggregate supply to decrease this is cost push inflation and this causes the short-run Philips curve to be shifted outwards from SRPC - SRPC1

decrease supply

The decrease in supply is assumed to be the exact amount for the natural rate to be restored this is depicted by Point C being on the long run Phillips curve

adverse effect

The adverse effect is the demand pull inflation displayed by the short run Phillips curve this affects policymakers as they would faced opportunity cost of having low unemployment

but the cost of high inflation