20 - Low and Stable Inflation

What is inflation?

Defined as a persistent increase in APL in the economy usually measured through calculation of a consumer price index

Costs of high inflation (7)

1. loss of purchasing power

   • If price of good increase, but income doesn’t change or not enough, can no longer buy as much

2. effect on saving

3. effect on economic growth

   • if people want to save - may choose to buy fixed assets

     • fewer savings in economy for investment

4. effect on interest rates

   • commercial banks make money by changing interest

     • if inflation rate increases, banks increase nominal IR

5. effect on international competitiveness

   • if country has higher rate of inflation than of trading partners - exports less competitive, imports more attractive

     • lower export revenue and higher import expenditure, worsen trade balance

6. Uncertainty

   • firms discouraged from investing - uncertainty of inflation

7. labour unrest

   • workers feel wages are not keeping up with inflation

     • disputes between unions and management

Winners of inflation

• people with index-linked income

• people with high wage bargaining power

• borrowers - real interest rate lowered by inflation - amount paid back now worth less

• people who are “asset rich“

  • buy assets as opposed to spending

  • increase p of assets

• importers - price of domestic increases, import demand increases

Losers of inflation

• Fixed income/wages

• low wage bargaining power

• savers/lenders - real IR lowered by inflation, amount received worth less

• people who are cash rich

  • value of cash decreases over time

• exporters - less attractive abroad as higher P make them compare less favourably with foreign

How is inflation measured?

Consumer price index

Basket of good - when p of basket increases, APL has risen

• different categories, different weights

Issues in measuring CPI

• CPI - typical consumption of a household, doesn’t apply to all

  • variations in regional rates - national figures typically used

  • doesnt reflect accuracy of groups

• Errors in data collection

  • larger the sample, more accurate, costs money and time

• Due to consumption habits - items removed/added over time

  • if items are changed, hard to make comparisons

  • Further complicated by change in quality.

• Countries measure differently - hard to make international comparison

• Prices change for variety of reasons that are not sustained

  • e.g seasonal food prices

• CPI measures change in consumer prices, indicates common economy health

  • other prices change essential for doing this

    • economists measure change in FOP’s

Commodity prices - change

Upward movements in price - signal of cost push pressures and may be leading indicators of inflation

Producer Price index

tracks price of goods as leave the factories before distributors, wholesalers or retailers and their profit margin

Causes of inflation - two types

demand pull and cost push

How does D inflation work - brief

Increase demand in the industry

• prices up from APL1 to APL2

Change in AD can be sue to changes in the components

How does cost push inflation work - brief

• increase in COP

• increase in costs fall in sras

• Wage -push inflation, increase in APL due to increase in labour costs

• Fall in countries currency - import-push inflation

  • lower exchange rate makes imports more expensive, increases cost of imported FOP’s to countrys firm

Inflationary spiral

Ad keeps going up due to increased wealth, If Ad increases, demand-pull, workers demand higher wage as APL increased. Shift in SRAS due to cost push.

Inflation is a short run problem - supply side policy

• supply-side policies not suitable

  • successful policies reduce APL over time, but time lag too great

Gov intervention for demand-pull

GOV and CB should use contractionary monetary and fiscal policy to reduce AD

Why is cost-push hard to intervene with

• Caused by rising COP’s, policy makers have no control over

  • demand side policies needed to fight inflation

Problems with contractionary policies

Highly unpopular from a political standpoint

1. Fiscal

   • voting population not happy to accept higher taxes as it reduce disposable income

   • reduction in gov spending - impacts groups of people

   • takes time - time lag too long

2. Monetary

   • higher IR harm people in economy, especially with loan or mortgage

   • less borrowing, less investment, harm economy

Which policy is considered most effective

Monetary, IR considered best weapon

What is deflation

Persistent fall in average price level

“Good“ deflation - how does it work

• improved in supply side of the economy, and/or increased productivity

• Increase in LRAS - increase in real output, fall in price level

Bad deflation - how does it work

• demand side of economy

  • fall in AD, decrease in APL, decrease in real output, increase unemployment

Disinflation

falling rate of inflation

• prices rise, but inflation can reduce

Costs of “bad“ deflation

• Unemployment

  • AD decreases, lay off workers, AD decreases more

  • deflationary spiral

• Deferred consumption

  • put off purchase of durable goods, wait for p to drop more

    • fall in AD, deflationary spiral

• falling consumer confidence

  • households become pessimistic about economic future, consumer confidence lowers

    • deflationary spiral

• effect on investment

  • Business make less profit, lay off workers. Business confidence low, likely to reduce investment

• costs to debtors

  • Anyone who has taken a loan suffers, value of their debt rises. If profits low, difficult to pay loans - bankruptcies, further lower confidence

• policy ineffectiveness

  • Deflation make monetray ineffective. very low/negative interest rates with deflation make expansionary monetary ineffective, not possible to reduce IR to increase AD

What does the weighted price index do

Take a basket of products, which are given a different weight, based upon relatives amount people spend

Inflation rate calculation - basket

(Index for (X+1) - Index for X) / Index for X x 100

Og philips curve

• inverse relationship between rate of change of money wages (wages not adjusted for inflation) in economy and unemployment

Philips curve - low unemployment

If low unemployment, firms pay higher wages to attract labour

Philips curve - high unemployment

If high unemployment, workers compete, wages could be low

Philips curve

philips curve AD/AS

People expect inflation to be 2%, hence want higher wages

• unemployment drops, people interested in higher wages

• workers suffered from money illusion

• workers realise wages havent risen, leave jobs, unemployment

• back to natural rate, but now at a higher inflation

This is an on going cycle, resulting in higher inflation

Natural rate of unemployment

Rate that is consistent with stable rate of inflation. Economy is at full employment, labour market at eq.

• if gov doesnt use expansionary policies, inflation will not accelerate at natural rate of unemployment

Difference in unemployment between countries due to dif, factors

• availability of unemployment benefits

• trade union power

• extent of labour market regulations

• wage-setting practice

Countries with more benefits and regulations of markets tend to have…

higher rate of natural unemployment