Inflation, Hyperinflation and Deflation

Relative price changes

conveys information about scarcity and preferences

Chain of reasoning - mistaking absolute for relative price change - higher prices scenario

higher prices - lower consumption - lower AD EVEN THOUGH WAGES MIGHT BE RISING IN LINE WITH THE INFLATION LEVEL

Costs of reducing inflation

higher unemployment, unhappiness, political upheaval etc...

real world examples of hyperinflation

Germany in 1923 Zimbabwe in 2005-7 Argentina in 1988-90

real world examples of deflation

Japan

Mistaking absolute price changes for relative price changes is problematic because...

individuals make poor decisions based on incorrect data

Hyperinflation

monthly inflation that is greater than or equal to 50%

cause of deflation

mostly after contractionary AD shock - lower spending and investment in economy so lower AD leads to falling prices

ending deflation

printing lots of money - increase the money supply - lower the value of money/ PPP - increase in inflation

Inflation changes perceived and real...

relative price changes by obscuring the signal

Deflation

sustained and general fall in price level

Inflation

sustained and general rise in price levels

Price adjustment mechanism

when firms respond to inflation by changing prices at different times meaning that relative price changes just reflect the timing of the firms decisionmaking

Inflation rate

% change in price level

Cons of Inflation

1. Higher inflation --> higher uncertainty 2. Risk averse people worse off --> unlikely to invest 3. People forego potentially profitable opportunities 4. Higher transaction costs --> More time, resources and effort needed for financial planning

Pros of Inflation

1. Prevents deflation --> damaging and persistent cycle 2. Stay away from ELB --> no need for unconventional monetary policy

consequences of deflation

1. consumers delay purchases - prices fall daily so consumers continuously hold back spending until lowest price possible 2. increase in PPP - means that value of real debt increases and people feel poorer 3. can exacerbate recessions and becomes a vicious cycle

causes of hyperinflation

1. excessive money creation - increase money supply 2. large budget deficits financed by money creation - where country is closed from foreign lending and unable to do fiscal adjustments

ending hyperinflation

1. fiscal reform - increase taxes and lower govt spending 2. monetary reform - certain limit for money creation, having a currency peg and inflation target 3. central bank independence - guidelines from govt. but unable to just print money

consequences of hyperinflation

1. relative prices lose meaning - no signalling 2. planning impossible - day to day effort of detecting purchasing power prevents LT view 3. focus of survival - rapid fall in PPP 4. lower production levels

BoE target

2% BUT +/-1%

Measure of inflation

CPI (consumer price index)

What is CPI?

a measure of the overall cost of the goods and services bought by a typical consumer

How to lower inflation?

central bank induces a recession - higher i/r and lower G can be very costly

Absolute price changes

change in the units of measurement

Inflation target

commitment of central bankers to keep inflation below a certain rate for a period of time --> anchors expectation and stops self-fulfilling