inflation economics IB

Inflation (definition)

persistent increase in the average price level in the economy over time

costs of high inflation

• Loss of purchasing power

  • Inflation correlates with prices: if inflation is 5%, prices are 5% higher

  • Consumers (and producers) cannot purchase as much as they could before 

  • Results in a reduction in living standards

• Effects on saving

  • If the inflation rate is higher than the interest rate, then real interest rates are negative--savings are lost and saving is discouraged

  • E.g., If interest rates are 3%, but inflation is 5%, then purchasing power is lost and there is little incentive to save money 

• Effect on economic growth

  • If people choose to save their money on fixed assets that hedge against inflation (houses, gold, fine art, etc.), this means there is less capital available for investment purposes

• Effect on interest rates

  • If inflation is high, then banks raise interest rates (the cost of borrowing money) to keep a real rate of return; this means fewer consumers or firms will borrow money (reduced spending and investment)

• Effect on international competitiveness

  • Higher inflation rates mean exports become more expensive for foreign buyers; firms are less competitive on the international market and exports are reduced 

• Uncertainty 

  • Investment is reduced because of the uncertainty associated with higher rates of inflation (e.g., would you open a business in Turkey if the inflation rate--and therefore the increase in costs of production--was 15% over 5 years?) 

• Social unrest

  • Reduced purchasing power among citizens can often lead to social and political turmoil; the inability of wages to keep up with inflation may also lead to disputes between workers/unions and management

Inflation: Winners

• People with index-linked incomes (incomes increase with inflation) 

• Workers with high wage-bargaining power (workers in high-demand industries or strong trade unions) 

• Borrowers (especially the government!) -- real interest rates are lowered by inflation, meaning the amount of a loan repaid is worth less than the amount that was borrowed 

• Asset owners -- gold, houses, fine art, etc., are all hedges against inflation 

• Importers (as domestic products become more expensive, imports become more attractive

Inflation: Losers

• People on fixed incomes (pensioners) or wages (long term fixed wage contracts)

• Workers with low wage-bargaining power (unskilled workers, e.g., fast-food workers)

• Savers/lenders

• Hoarders of cash 

• Exporters (higher prices make exports less attractive) 

The Consumer Price Index (CPI)

• Inflation is measured by creating a price index of a “basket” of consumer goods, and then calculating the change in the index price from month to month

• Include items like rent, healthcare, certain foods, transportation, household items, etc. 

• Often weighted, as some goods take up a higher percentage of income than others 

• Basket items change to account for changing consumption patterns (e.g., envelopes are no longer included in the CPI) 

Problems with Measuring Inflation (CPI)

• The CPI represents spending habits of a “typical” household

  • Does not account for different types of households or regional inflation 

• Different rates of inflation for different income earners

  • E.g., Food price inflation has greater effect on low-income earners than higher income earners

• Changes in consumption patterns due to consumer substitutions

  • E.g., If laundry detergent becomes more expensive, consumers may switch to a cheaper substitute; this change in consumption is not accounted for in the CPI, and therefore provides a misleading indication of inflation levels

  • Consumers may also take advantage of sales and discount stores, buying goods and services at lower prices than those used in the CPI

• Basket items change to account for changing consumption patterns (e.g., envelopes are no longer included in the CPI) 

• Quality improvements not accounted for

  • E.g., If cars become safer and more technological, the price may increase to reflect those improvements. If cars are included in the basket, this equates to higher inflation, even though the product is not really the same

• Poor comparability 

  • Over time, cumulative changes to the basket make comparing price index numbers difficult

  • The basket of goods and method of weighting changes from country to country, making the CPI and inflation rates difficult to compare

• Exclusion of variable or volatile factors

  • E.g., Oil is excluded from the CPI, although it is a key raw material used in production and can have a major effect on the price of many goods

CORE INFLATION: Underlying rate of inflation to eliminate the effect of sudden fluctuations in the price of oil or food

Demand-Pull Inflation

• Inflation due to increasing AD as a result of any changes in the components of AD (C/I/G/X/M) 

  • Note: New Classical (“Monetarists”) and Austrian economists believe that inflation is always caused by excessive growth of the money supply by central banks

• Associated with an inflationary gap

  • RGDP greater than full employment GDP, and unemployment falls below the natural rate of unemployment

Cost-Push Inflation

• Inflation due to increases in costs of production or “supply shocks”

• Can only be represented by the new classical AD/AS model, as the Keynesian model cannot account for short-run fluctuations of AS 

• NOT a deflationary gap, as output gaps are only caused by excess/restricted AD (there is no deflation!)

• Also used to represent stagflation 

An Inflationary Spiral

• Inflation can perpetuate itself when demand-pull and cost-push inflation occur together: 

1. AD increases because of a change in one of its components (demand-pull inflation). 

2. Higher price levels result in an increase in the cost of production, shifting in the SRAS curve (cost-push inflation). 

3. HIgher wages result in further consumption, increasing demand-pull inflation and higher price levels. Etc., etc. 

Deflation

persistent decrease in the average price level of the economy

“Good” Deflation

• Occurs as a result of improvements in the supply side of the economy, usually increased productivity 

• Results in outward shift of LRAS curve, increased output, and lower unemployment, as more workers are needed to produce more output

• Overall reduction in average price level

“Bad” Deflation

• Occurs as a result of reduced AD

• Results in reduced real output average price levels 

• Reduced output = higher unemployment

  • Reduced spending and therefore reduced economic growth

What Are the Costs of “Bad” Deflation?

• Higher unemployment 

  • Reduced AD means businesses will need to sack workers, which further reduces AD

• Redistribution effects

  • Individuals on fixed incomes (pensioners), cash holders, and savers and lenders (creditors) all see and increase in the real value of their income or assets, while borrowers (debtors) and payers of fixed incomes lose 

• Increase in the real value of debt

  • Deflation means an increase in purchasing power, and therefore and therefore the real value of debt increases 

• Uncertainty

  • This can translate into reduced consumer confidence, which negatively affects AD; similarly, firms are unable to forecast costs and revenues

• Less investment

  • Reduced price levels mean lower profits for businesses, which leads to less investment, reduced AD and stagnating economic growth

• Deferred consumption 

  • If prices are falling, and consumers expect them to fall further, then they will postpone spending to take advantage of lower prices

  • A reduction in spending results in falling AD and higher unemployment, which perpetuates into a deflationary spiral (see diagram) 

• Risk of bankruptcy

  • If the real value of debt increases, and incomes and spending are falling, then many consumers and firms will be unable to pay their debts and go bankrupt

• Policy ineffectiveness

  • Monetary policy is ineffective because interest rates are so low (or zero, or negative) in a deflationary environment