2.3.1 Inflation

Inflation

Increase in overall price level of an economy

Deflation

Decrease in overall price level of an economy

Disinflation

Decrease in rate of inflation

(Price level still increases, just at slower rate)

CPI

• Consumer Price Index

• Basket of goods and services purchased by average household (includes indirect tax), weighted by importance of goods

• Used to compare inflation in a country over time

Limitations of CPI

• Doesn’t include housing costs/mortgage payments

• Doesn’t include different types of households (eg. pensioners)

• Doesn’t account for change in quality of goods

• Doesn’t include innovation

PPI

• Producer Price Index

• Basket of goods and services purchased by average firm

Use of PPI

• Usually reflects future trend in CPI/rate of inflation

Use of CPI

• Set pension rate

• Set wage rates

• Used by governments to check if meeting inflatio rates

Causes of inflation

• demand-pull

• cost-push

• excessive growth of money supply

Demand-pull inflation

Increase in Aggregate Demand (supply stays the same)

• Excessive consumer spending

• Rise in firm investment

• Tax cuts

• Rise in world demand for exports

Cost-push inflation

Decrease in Aggregate Supply (Aggregate Demand stays the same)

• Increase in wages

• Increase in import prices

• Rise in prices of inelastic goods (used to produce)

• Increase indirect taxes

• Rise in running costs of firms

Excessive growth of money supply

• Banks print more money of lend more easily

• → hyperinflation

Causes of deflation

• Falling AD

• Increasing AS

• Fall in money supply

(Opposite of inflation)

Costs of Inflation

• Consumers

  • Psychological costs

  • Shoe-leather costs

• Government

  • Lower national output, increased unemployment

  • Competitiveness of exports decrease (deficit)

• Firms

  • Menu costs 

• Workers

  • Redistributional costs (purchase less with same amount)

• Income distribution

  • Inequality increases

• Investments

  • Harder to plan for

• Competitiveness

  • Exports less attractive, imports more attracive

• Current account of balance of payments

  • Deficit in BoP

Costs of deflation

Consumers

• Psychological costs - people feel better off

Government

• Lower national output, increased unemployment

• Competitiveness of exports increase(surplus)

Firms

• Reduced revenue + profits

Workers

• Lower wages

Income distribution

• Inequality worsens

Investments

• Investments discouraged

Competitiveness

• Exports more attractive, imports less attractive

Current account of balance of payments

• Surplus - more exports than imports