chapter 8.3 - inflation and deflation

inflation

a continuing rise in the average price level - mainly caused by excess aggregate demand in the economy, or a general rise in costs of production

deflation

a continually falling price level

demand pull inflation

a rising price level caused by an increase in aggregate demand, shown by a shift right of the AD curve

causes of demand pull inflation

an increase in any of the components of aggregate demand

how the effect of an increase in aggregate demand varies along the SRAS curve

as the AD curve shifts right and moves closer to the LRAS curve, increasingly, the reflation of real output + employment gives way to the inflation of the price level

cost push inflation

a rising price level caused by an increase in the costs of production, shown by a shift left of the SRAS curve

causes of cost push inflation

rise in the costs of production; fall in the exchange rate; fall in productivity; increase in trade union power

wage cost inflation

a rising price level caused by an increase in wages and salaries, shown by a shift left of the SRAS curve

main cause of wage cost inflation

a rising salary of e.g. bankers, top business executives, premier league footballers - salaries increase more than their productivity

import cost inflation

a rising price level caused by an increase in the cost of imported energy, food, raw materials and manufactured goods; shown by a shift left of the SRAS curve

emerging market countries

a country that is progressing towards becoming more economically advanced, by means of rapid growth and industrialisation

disinflation

when the rate of inflation is falling, but the price level is still rising, just more slowly

government policy to control demand pull inflationq

raising or lowering interest rates i.e. monetary policy

monetarists

economists who argue that a prior increase in the money supply is the cause of inflation

quantity theory of money

the oldest theory of inflation, which states that inflation is caused by a persistent increase in the money supply - too much money chasing too few goods

equation of exchange

stock of Money in the economy (money supply) x Velocity of circulation of money = Price level x Quantity of real output in economy --> MV = PQ

monetarists view of the equation of exchange

monetarists argue that V is stable = when M increases, its spent on goods + services - if Q is unable to increase, P is pulled up by excess demand

Keynesian economists view of the equation of exchange

when M increases, it may be partially absorbed by a slowdown in V = much of the extra money isn't spent on goods + services - but some extra money might be spent on investment in new capital goods = positive impact on AD, stimulating Q rather than P

effect of expectations on price level

if people expect that the rate of inflation next year is going to be high, they will behave in an inflationary way now, which will contribute to high inflation next year

cost of zero inflation

results in absolute price stability, which produces wage stickiness, which results in unnecessarily high unemployment

costs of inflation

distributional effects; distortion of normal economic behaviour; breakdown in functions of money; international competitiveness; shoe leather costs; menu costs

how does inflation cause distributional effects

weaker social groups living on fixed incomes lose, whilst those in strong bargaining positions gain; real rates of interest may be negative = lenders are paying borrowers

how does inflation cause distortions of normal economic behaviour

households may bring forwards purchases; firms may divert funds out of productive investment into unproductive commodity hoarding

how does inflation cause a breakdown in the function of money

money becomes less useful and efficient as a medium of exchange and a store of value

how does inflation cause international competitiveness

when inflation is higher than other countries, exports increase in price, putting pressure on fixed exchange rate - exchange rate may fall to restore competitiveness, but rising import prices may push inflation higher

how does inflation cause shoe leather costs

consumers have to spend extra time and effort shopping around and checking which prices have or haven't risen

how does inflation cause menu costs

firms have to adjust prices more often

costs of deflation

people my postpone large consumption decisions e.g. buying a new car = reduces business confidence + triggers/deepens recession