8.3 Inflation and deflation

List potential benefits of inflation.

Low stable rates from demand pull inflation may encourage firms to increase output. Firms can use inflation to adjust real wages. Staff may resist nominal wage cuts but accept a wage increase below the rate of inflation

Is deflation a problem?

One-off falls in prices increase purchasing power stimulating consumption, and AD. Falling asset prices (eg houses & equities) reduce personal sector wealth. Households may increase savings in attempt to restore previous wealth levels Sustained price falls can set off a deflationary spiral. Consumers postpone purchases in anticipation of further price falls. Firms then cut prices in the hope of stimulating sales.

What is demand-pull inflation?

A rising price level caused by an increase in AD shown by a shift in AD to the right.

What is wage-cost inflation?

A rising price level caused by an increase in wages and salaries shown by a shift of the SRAS curve to the left.

List potential sources of cost push inflation.

An increase in wage rates, import prices or prices of raw materials, fuel, energy and components used in production

What are emerging market economies?

Country that is progressing towards becoming more economically advanced by a means of rapid growth and industrialisation.

What is deflation?

Deflation refers to a sustained decrease in the price level. Purchasing power increases and households can buy more products with their income

What are some macro policies to control inflation?

Fiscal policy: Less spending on public or merit goods or welfare benefits or increasing taxes Monetary policy: Higher interest rates-may cause exchange rate to depreciate, bringing cheaper imports and services Supply side policies: increase innovation and production Direct control: Public sector pay controls Capping or other regulation of prices of utilities

What are some external causes of inflation?

Increase in world oil prices Global inflation of commodity prices Depreciation of exchange rate High inflation of other countries.

Why is high inflation an economic problem?

Inequality: Regressive effect on lower income families Fall in real incomes Negative real interest rates: Cost of borrowing- higher interest rates Risk of wage inflation-rising labour costs and lower profits. - can cause unemployment. Reduce business competitiveness- lowers our countries demand for exports. Business uncertainty-fall in capital investment

What is inflation?

Inflation is a sustained rise in the price level. This means that, on average, the prices of products in an economy are going up over time. As the price level rises each pound buys fewer products. This means the value or purchasing power of money falls.

How is inflation measured?

Inflation is usually reported as the percentage change in the price level, over the last 12 months. Economist talk about the annual rate of inflation

What are the consequences of inflation?

Menu costs: re-pricing cost to firms eg changing price lists and displays or printing new catalogues Shoe leather costs: eg making additional trips to the bank to put cash into interest bearing accounts Income may be redistributed eg creditors lose if the interest charged does not compensate for inflation Inflationary noise: economic agents are unsure if a price rise is due to inflation or an rise in the relative price of a product eg a car Uncertainty about future prices increases risk and so discourages investment. Inflation generating inflation eg firms raise prices and staff demand higher wages anticipating inflation Fiscal drag: rising incomes draw workers into higher fixed tax brackets causing a higher proportion of income to be paid in tax Lost international competitiveness if domestic inflation rates exceed rivals

What determines the impact of inflation? The overall effects of inflation depend on its

Rate: a 1% annual inflation rate doubles prices every 72 years. A 10% inflation rate doubles the price level every 7.2 years. Duration: the longer inflation lasts, the greater its impact Trend : accelerating or fluctuating inflation is a bigger threat than stable inflation rates. Relative international rate. If UK inflation rates are higher than our trading partners, price competitiveness is lost. Imports are encouraged; exports are discouraged.

Who are the losers of inflation?

Retired on fixed incomes Lenders if real interest rates are negative Savers if real returns are negative (pensioners) Workers in low paid jobs.

What is import-cost inflation?

Rising price level caused by increase in the cost of energy, food, raw materials and manufactures goods. Shifting SRAS curve to left.

How is the annual rate of inflation measured?

The annual rate of inflation is found by calculating the percentage change in a given price index eg the CPI, over the last 12 months

Define the inflation rate.

The percentage change in the price level over a given period of time.

What is inflationary pressure?

Upward forces on the price level from cost push or demand pull inflation factors. Firms may opt to hold or raise prices to maintain margins

Who are the winners in inflation?

Workers with strong wage bargaining power Debtors if real interest rates are negative(uni student loans are worth less) Producers if prices rise higher than costs

Contrast demand pull with cost push inflation.

Excess AD is demand pull. A general rise in cost of production is cost push.