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