Economics- Inflation

AS91222 2.1

inflation

a sustained increase in the general price level of goods and services in an economy

CPI

consumer price index- measures changes in price of basket of goods/ services that represents what the average household purchases

weighting

a percentage value assigned to a specific good/ service to show how much a typical household budget goes towards buying it

calculating inflation

new CPI - old CPI / old CPI x 100

why does inflation matter

it means money loses purchasing power

demand pull inflation

caused by increased AD

cost push inflation

caused by increased costs of production

nominal

measured in current prices without adjusting for inflation

real

adjusted for inflation to show true purchasing power

Inflation rate

The percentage change in the general price level over a period of time.

Deflation

A sustained decrease in the general price level.

Purchasing power

The amount of goods and services that can be bought with a given amount of money.

Real income

Income adjusted for changes in the price level; it represents the purchasing power of income.

Consumer Price Index (CPI)

A measure of changes in the prices of a basket of goods and services typically purchased by households.

Demand-pull inflation

Inflation caused by aggregate demand increasing faster than the economy's ability to produce goods and services.

Cost-push inflation

Inflation caused by an increase in the costs of production, which reduces aggregate supply.

Real GDP

The value of final goods and services produced in an economy, adjusted for changes in the price level.

Nominal GDP

The value of final goods and services produced in an economy measured using current prices.

Investment (I)

Spending by firms on capital goods such as machinery, buildings and equipment.

Causes of cost-push inflation

Higher wages, higher raw material prices, higher energy prices, higher taxes on businesses, supply shortages or natural disasters can increase production costs and cause cost-push inflation.

Decrease in income tax

A decrease in income tax increases households' disposable income, increasing consumption and AD, which can increase the price level and inflation.

Increase in OCR

An increase in the Official Cash Rate increases borrowing costs, reducing consumption and investment, decreasing AD and reducing inflationary pressure.

Decrease in OCR

A decrease in the Official Cash Rate reduces borrowing costs, increasing consumption and investment, increasing AD and potentially increasing inflation.

Contractionary monetary policy

Monetary policy designed to reduce AD and inflationary pressure, usually by increasing interest rates.

Expansionary monetary policy

Monetary policy designed to increase AD and economic activity, usually by decreasing interest rates.

Contractionary fiscal policy

Fiscal policy designed to reduce AD and inflationary pressure, usually through lower government spending and/or higher taxes.

Expansionary fiscal policy

Fiscal policy designed to increase AD and economic activity, usually through higher government spending and/or lower taxes.

Effect of inflation on consumers

Inflation reduces the purchasing power of money, meaning consumers can buy fewer goods and services with the same nominal income.

Effect of inflation on savers

If interest earned on savings is lower than the inflation rate, the real value/purchasing power of savings decreases.

Effect of inflation on borrowers

Inflation can reduce the real value of existing debt, benefiting borrowers when their income rises while the nominal debt remains fixed.

Effect of inflation on exporters

High domestic inflation can make New Zealand goods relatively more expensive, reducing international competitiveness and potentially decreasing exports.

Effect of inflation on importers

High domestic inflation can make imported goods relatively cheaper compared with domestically produced goods, potentially increasing imports.

Effect of inflation on businesses

Inflation can increase firms' input costs and make pricing and investment decisions more difficult.

Effect of inflation on economic growth

High or unpredictable inflation can reduce investment and economic efficiency, potentially lowering long-term economic growth.

Inflation and unemployment

In the short run, policies that reduce inflation by decreasing AD can also reduce real GDP and increase cyclical unemployment.

Stagflation

A situation where inflation occurs at the same time as falling or weak real GDP and rising unemployment.

Inflationary gap

The amount by which actual output exceeds the economy's sustainable/full-employment level of output, creating upward pressure on prices.

Opportunity cost of reducing inflation

Reducing inflation through contractionary policy can reduce economic growth and increase unemployment in the short run.

quantity supply of money

economic model used to show the link between amount of money circulating in an economy and the price level

money supply

the amount of money that is available or circulating in an economy

velocity of circulation

the rate at which money is spent- how many times it circulates

crude (simple) theory

velocity and GDP held constant

sophisticated quantity theory

V and Q are not constant- any increase in the money supply during a boom will have more than proportionate impact on the price level