Ncea Level 2 Inflation

inflation Inflation is the rate at which the general level of prices for goods and services increases, leading to a decrease in the purchasing power of money (illustrated by the CPI). Disinflation The reduction in the rate of inflation, meaning prices are still rising but at a slower rate. Deflation The decrease in the general level of prices for goods and services, resulting in an increase in the purchasing power of money. Describe why inflation reduces the purchasing power of money As prices rise due to inflation, each unit of currency buys fewer goods and services, reducing purchasing power. Describe the difference between • general price rise in the price level • individual price rises in a particular market While a general price rise refers to an overall increase in the average price level of goods and services in the economy, often measured by the Consumer Price Index (CPI), an individual price rise occurs when the price of a specific good or service increases within a particular market, which may not necessarily reflect the broader economic trend, for example the price of parking tickets or EV's. Nominal Indicators Nominal indicators are economic measures not adjusted for inflation, like nominal wage and nominal GDP. Real Indicator Real indicators are economic measures adjusted for inflation, like real wage and real GDP. Difference between nominal and real indicators Nominal indicators are measured in current monetary terms without considering inflation, whereas real indicators are adjusted for inflation to reflect true economic value. The quantity theory of money (QTOM) The quantity theory of money states that the general price level of goods and services is directly proportional to the amount of money in circulation, assuming the velocity of money and the real output of the economy remain constant. QTOM: MV = PQ. Define each variable in the quantity theory of exchange The equation of exchange 𝑀𝑉 = 𝑃𝑄 represents the relationship between the money supply (𝑀), the velocity of money (𝑉), the price level (𝑃), and the quantity of goods and services produced (𝑄). 𝑀 is the total amount of money in circulation, 𝑉 is the frequency at which money is exchanged, 𝑃 indicates the average price level, and 𝑄 reflects the real output of the economy. Together, they show how changes in the money supply and velocity affect the overall price level and economic output. Use the quantity theory of exchange to • explain how money supply changes would affect inflation (crude theory) According to the quantity theory of exchange 𝑀𝑉 = 𝑃𝑄, if the money supply (𝑀) increases while the velocity of money (𝑉) and the real output of goods and services (𝑄) remain constant, the price level (𝑃) must rise, leading to inflation. This is because more money is chasing the same amount of goods and services, causing prices to increase. Use the quantity theory of money to identify and explain how changes in V and/or Q affect inflation (assuming M unchanged) (sophisticated theory) According to the quantity theory of money 𝑀𝑉 = 𝑃𝑄, if the money supply (𝑀) remains constant, an increase in the velocity of money (𝑉) or a decrease in real output (𝑄) will lead to a rise in the price level (𝑃), causing inflation. This happens because an increase in 𝑉 means money is circulating faster, creating more demand for goods and services. A decrease in 𝑄 means fewer goods and services are available, leading to higher prices. Conversely, a decrease in 𝑉 or an increase in 𝑄 would result in a lower price level, reducing inflation. Aggregate Demand Aggregate Demand (AD) is the total demand for all goods and services in an economy at a given overall price level and in a given period. AD = C + I + G + (X-M) Aggregate Supply Aggregate Supply (AS) is the total supply of all goods and services that firms in an economy plan to sell at a given overall price level and in a given period. Cost Push Inflation Cost-Push Inflation is inflation that occurs when rising production costs, such as wages and raw materials, compel producers to increase prices to maintain profit margins, reducing overall economic supply and increasing the overall price level. Demand Pull Inflation Demand-Pull Inflation is inflation that arises when the overall demand for goods and services exceeds their supply, leading to higher prices driven by increased consumer spending, government expenditure, or investment. Nominal costs of production Nominal Costs of Production are the expenses incurred in producing goods or services, measured in current monetary terms without adjusting for inflation, reflecting the immediate financial outlay. Identify and explain two factors that causes an increase in consumption (C) leading to demand pull inflation 1. Increase in Consumer Confidence When consumers feel more confident about their financial future, they are more likely to increase their spending on goods and services. Higher consumer spending boosts aggregate demand (AD), leading to demand-pull inflation as businesses raise prices to keep up with the increased demand. 2. Lower Interest Rates Lower interest rates make borrowing cheaper for consumers, encouraging them to take loans and spend more on goods and services. This increase in consumption results in higher aggregate demand (AD), which pushes prices up and causes demand-pull inflation. Identify and explain two factors that causes an increase in investment (I) leading to demand pull inflation 1. Decrease in Official Cash Rate (OCR)/Interest Rates A decrease in the OCR or interest rates reduces the cost of borrowing for businesses. This encourages businesses to invest more in capital projects and expansion activities, thereby increasing aggregate demand (AD) and contributing to demand-pull inflation as the increased demand for resources and labor drives prices up. 2. Increase in Business Confidence When businesses are optimistic about the economic outlook, they are more likely to invest in new projects and expand their operations. This increased investment raises aggregate demand (AD), resulting in higher prices and demand-pull inflation as businesses compete for resources. Identify and explain a factor that causes an increase in Government spending (G) leading to demand pull inflation Increase in Education Spending When the government allocates more funds to education, it boosts demand for educational services and related industries. This increase in government spending raises aggregate demand (AD), leading to demand-pull inflation as the higher demand for educational services and associated resources drives prices up. Identify and explain two factors that causes an increase in net exports (X - M) leading to demand pull inflation 1. Increase in Export Receipts When a country's exports rise, it brings more money into the economy (injection) from foreign buyers. This inflow of funds increases aggregate demand (AD), contributing to demand-pull inflation as businesses raise prices to meet the higher demand for their goods and services. 2. Decrease in Import Payments due to depreciation of NZD If the local currency depreciates, imports become more expensive, leading consumers to purchase more domestic goods instead of foreign ones. This shift towards domestic consumption increases aggregate demand (AD), resulting in higher prices and demand-pull inflation as businesses struggle to keep up with the increased demand for locally produced goods. What is the formula to calculate GDP GDP = C+I+G+(X−M) C (Consumption): This represents the total spending by households on goods and services within the economy. I (Investment): This includes business expenditures on capital goods, residential construction, and changes in business inventories. G (Government Spending): This encompasses government expenditures on goods and services, including public sector salaries, infrastructure projects, and defense. X (Exports): This accounts for the value of goods and services sold to foreign countries. M (Imports): This represents the value of goods and services purchased from foreign countries and is subtracted from the total because these expenditures are not on domestic goods and services. Identify and explain why an increase in nominal wages causes cost push inflation When nominal wages rise, the cost of labor for firms increases. This higher cost of production results in firms raising their prices to maintain profit margins, leading to cost-push inflation. As production costs rise, aggregate supply decreases, putting upward pressure on the overall price level. Identify and explain why an decrease in worker productivity causes cost push inflation A decline in worker productivity means that firms are producing fewer goods and services with the same amount of input. This inefficiency raises the per-unit cost of production, forcing firms to increase prices to cover these costs, resulting in cost-push inflation. The decrease in productivity reduces aggregate supply, contributing to higher prices. Identify and explain why an decrease in technology causes cost push inflation When technology advancement regresses, production processes become less efficient. This leads to higher production costs as firms have to rely on outdated methods. As a result, firms increase prices to cover the additional costs, causing cost-push inflation. The reduction in technological efficiency leads to a decrease in aggregate supply. Identify and explain why an increase in the overseas price of raw materials causes cost push inflation When the price of imported raw materials rises, firms face higher input costs. To maintain profitability, firms pass these costs onto consumers in the form of higher prices, leading to cost-push inflation. The increase in raw material costs reduces aggregate supply, driving prices up. Identify and explain why an increase in GST causes cost push inflation An increase in GST raises the overall cost of goods and services. Firms pass this increased tax burden onto consumers by raising prices, leading to cost-push inflation. The higher tax rate reduces aggregate supply by increasing production costs. Identify and explain why a depreciation of the exchange rate causes cost push inflation When the local currency depreciates, the cost of imported raw materials and goods rises. Firms face higher input costs and increase their prices to cover these costs, resulting in cost-push inflation. The depreciation of the exchange rate decreases aggregate supply by making imports more expensive, contributing to higher prices. 2. Identify New Zealand's current position on the business cycle New Zealand is currently in the recovery phase of the business cycle. Following a period of economic slowdown, recent data indicates improving business confidence and a gradual increase in economic activity. However, growth remains below historical averages, and the recovery is still ongoing. Explain how a recession is likely to impact inflation During a recession, economic activity declines, leading to lower consumer and business spending. This reduced demand exerts downward pressure on prices, resulting in low or even negative inflation rates. Explain how a trough is likely to impact inflation At the trough, the economy reaches its lowest point. Inflation remains subdued as demand is still weak, but the decline in prices may start to stabilize as the economy prepares to recover. Explain how a recovery is likely to impact inflation In the recovery phase, economic activity picks up, with increased consumer and business spending. This rising demand can lead to moderate inflation as firms raise prices to match the growing demand. Explain how a boom is likely to impact inflation During a boom, the economy experiences rapid growth, high consumer and business spending, and low unemployment. This high demand puts significant upward pressure on prices, leading to higher inflation rates as firms struggle to keep up with demand. What are the flow on effects of inflation on New Zealand businesses? 1. Increase in Costs of Production: As inflation rises, the costs of raw materials and labor increase. This leads to higher production costs for businesses, which may reduce profit margins unless they pass on these costs to consumers through higher prices. 2. Distorts Price Signals: Inflation can distort price signals by causing prices to rise more generally, making it difficult for businesses to determine whether price changes are due to genuine supply and demand shifts or just overall inflation. This can lead to suboptimal business decisions. 3. Harder to Reinvest: With rising inflation, the cost of capital goods increases, making it more challenging for businesses to reinvest in new equipment, technology, and infrastructure. This can hinder business growth and productivity as reinvestment becomes more expensive. 4. Encourages Speculative Investment: High inflation encourages businesses to focus on speculative investments that quickly appreciate in value rather than long-term, productive investments. This shift can lead to economic inefficiencies and reduce the overall productivity of the economy. Describe and explain the flow on effects of inflation on households. 1. Fixed Income (Beneficiaries): Households on fixed incomes, such as beneficiaries, face a decline in their purchasing power as inflation erodes the real value of their income. This means they can buy fewer goods and services with the same nominal income, leading to financial strain. 2. Discourages Saving: Inflation discourages saving because the real return on savings falls. As prices rise, the principal saved is worth less in real terms, reducing the incentive to save. Households may prefer to spend rather than save, knowing their money will lose value over time. 3. Encourages Borrowing: Inflation encourages borrowing as the value of assets increases relative to the loan. The principal repaid is less in real terms, and the real interest rate paid is lower. Households may take advantage of this by borrowing to invest in assets that will appreciate over time. 4. Creates Fiscal Drag: Inflation creates fiscal drag by pushing households into higher tax brackets without an increase in real income. This reduces disposable income and can negatively impact household spending and savings. 5. Asset Owners Benefit: Households that own assets benefit from inflation as the value of their assets increases more than the inflation rate. This increase in asset value provides a hedge against inflation and can improve the financial standing of asset owners. Describe and explain the flow on effects of inflation on the Government Operating Balance. 1. Government Spending: Rising costs and prices due to inflation mean the government will have to spend more on public services such as health, education, and police. This increased expenditure strains the operating balance as the cost of providing these services escalates. 2. Government Spending on Benefits: Beneficiaries may demand increases in their benefits to offset the fall in real income and purchasing power caused by inflation. This additional spending requirement further increases government expenditure, impacting the operating balance negatively. 3. Government Income from GST: Higher prices and inflationary expectations lead to increased consumer spending, raising revenue from Goods and Services Tax (GST). This boosts government income, positively affecting the operating balance. 4. Government Income from Income Tax: As inflation pushes incomes higher, more people move into higher income tax brackets, resulting in increased income tax revenue for the government. This rise in tax revenue positively impacts the operating balance. Overall Effect: The overall effect of inflation on the Government Operating Balance depends on whether the positive impact of increased tax revenue from GST and income tax outweighs the negative impact of increased government spending due to higher costs. If tax revenue increases more than the additional spending, the operating balance improves. Conversely, if spending rises more than the tax revenue, the operating balance deteriorates.