Chapter 40: inflation and deflation

Deflation - define, effect on cost of living and value of money

A fall in the general price level in the economy. Cost of living decreases and the purchasing power of your money increases. There is a negative inflation rate ie -2%.

Inflation - define, effect on cost of living and value of money

A sustajned rise in the general price level over time. This means cost of living increases and the purchasing power of money decreases.

The danger of deflation

Deflation bring about a rising value in money as the general price level decreases - even though the purchasing power of households money is increasing households will offset spending as they wait for prices to fall further. Sudden fall in consumption = fall in aggregate demand. Firms will reduce their cost of production and supply to meet the reduced demand and maximise their profits. This may result in employees being made redundant. Outcome = huge decrease in real GDP. AD suffering from deflation falls for second reason. The burden of debt will increase. So: households with mortgages and firms weigh loans will find the real value of their debt increases. Households will be reluctant to spend, firms will offset investment = AD falls. Also deflation increases the debt of governments - further contributing to the budget deficit = gov reduces its spending. Real interest rates (interest rate - the rate of inflation) will become positive. So if the deflation rate is -2%, then real interest rates will be (0.5- -2) which is 2.5%. This incentives saving at the expense of spending and investment as cost of borrowing is high. The dangers: A. Fall in spending thus fall in investment by firms = AD falls B. Debt is increasing - households, firms and government reluctant to spend or invest = ad falls. C. Value of real interest rates increases - because the inflation rate in negative - so incentive to save increases - cost of borrowing increases so spending and investment decreases.

Causes of demand pull inflation

Demand pull inflation: an increase in AD results this form of inflation; increase in demand = prices are pushed up from p1 to p2 = this incentivises firms increasing their output hence from y1 to y2; factors of production are being utilised so so employment is high. In this situation - AD is at the steep and inelastic part of SRAS and so economy is operating at or full capacity.

Disinflation is:

The falling rate of inflation. This is when the average price level is still rising just like inflation, but the difference is with disinflation the inflation rate has basically decreased over time. Ie if price level increased by 4% from 2014 to 2015 that's just inflation. But a fall in inflation rate from 4% to 2% is disinflation because general price level is still high but just not as high as last year - so cost of living is cheaper and the purchasing power of money has increased.

What's the aim of deflationary government policies and what it brings about

To reduce AD and it does not necessarily bring about deflation - normally just a fall in the inflation rate so cause disinflation.