DK

Ch 20 - Macroeconomic Objectives: Low and Stable Rate of Inflation

  • Managing the change in the average price of level and achieving low and stable inflation rate → key objectives of government macroeconomic policy

  • Inflation: is the sustained increase in general price levels in an economy

  • Disinflation: fall in the rate of inflation in an economy

  • Deflation: sustained decrease in the general price levels in an economy

  • Consumer Price Index (CPI): the price index governments use to measure the rate of inflation

    • Weighted on the basis of consumer expenditure
    • Annual percentage in the change in the index is the inflation rate

  • Constructing a weighted price index:

    • Price index value = current year price / base year price * 100
    • Weighted index = weight * price / 100
    • Rate of inflation = percentage change in the weighted index

  • Limitations of measuring inflation:

    1. One-off changes in price
    2. Variation between countries
    3. Change in quality of goods
    4. Types of retailer prices vary
    5. Regional variation

  • Demand pull inflation: occurs when a rise in aggregate demand in the economy causes pulls in the price level in the economy to increase

    • Illustrates a rise in AD, leads to a rise in the average price level

  • Inflationary gap: periods of demand pull inflation lead to inflationary gap where the short run equilibrium is at a level of real GDP above the full employment level of income

    • actual output is above potential output

  • Cost push inflation: occurs when there is a reduction in the short run AS in the economy and price level is pushed up by rising costs

    • Rising costs causes the short run AS to shift which leads to a rise in average price level and a fall in real output

  • The SRAS curve will shift to the left is the cost of these factors increases:

    • Wage push inflation: when wage rises faster than output unit or average costs rise
    • Higher prices if firms choose to pass on the increase in unit costs as a higher price

  • Raw material costs: cost push inflation can be caused by rising commodity prices when increase the cost of manufactured goods

  • Capital costs: if the prices of machinery and equipment

  • Effects of inflation:

    • Impacts cost of living; price level rises in the economy the cost to households increases
    • Inflation has a negative effect on disposable incomes of households where wages cannot keep up with the increase in average price level
    • Reduces competitiveness

  • Deflation: negative rate of inflation where there is sustained fall in the general level of prices in an economy

  • Demand side deflation: deflation can occur because of a fall in AD and typically occurs in a recession

  • Supply side deflation: deflation that occurs on the supply side arises when the AD curve shifts to the right and leads to a higher output at lower prices

    • It is called “good deflation” as it is associated with higher level of real GDP

  • Effects of deflation:

    • Reduced growth and deflation
    • Falling consumer consumption
    • Redistribution of goods
    • Rise on spending power

  • Phillips curve: graph which represents the rate of unemployment and rate of change of money wages. Indicated that wages tend to rise faster when unemployment is low