Inflation

What is the difference between inflation and disinflation?

Deflation is the decrease in the general price level. It can also be referred to as negative inflation. Disinflation is a fall in the rate of inflation (i.e., from 4% to 2%).

Name two causes of inflation. Explain how they work.

Demand-pull inflation: As the name suggests, demand-pull inflation occurs as a result of increasing aggregate demand in the economy. Cost-push inflation: Cost-push inflation occurs as a result of an increase in the costs of production.

How can inflation be caused by excess monetary growth?

If there is more money in the economy, then there will be more spending, thus higher aggregate demand. Increases in the money supply result in higher aggregate demand from AD1 to AD2. Because the economy rests at the full employment level of output in the long run, such increases in aggregate demand due to increases in the money supply are purely inflationary, with the price level rising from P1 to P2.

What is an inflationary spiral?

Self-sustaining upward trend in general price levels fueled by the reinforcing feedback of a vicious circle. Wage price spiral is a typical example of an inflationary spiral: high cost of living prompts demands for higher wages which push production costs up forcing firms to increases prices, which in turn trigger calls for fresh wage increases ... and so on. Such situations continue until radical measures (such as incomes policy) are instituted to break the cycle, otherwise the currency is rendered almost worthless as a medium of exchange (as it happened in Germany in the 1920s, in Brazil in the 1980s, and in Argentina in the 1990s) and has to be replaced with new monetary units (currency).

Name 2 costs of inflation. Explain.

The answer could be two of the following: • Loss of purchasing power: If the rate of inflation is 2%, then this means that the average price of all goods and services in the economy has risen by 2%. • Effect on saving: If you save $1,000 in the bank at 4% annual interest, then in one year's time you will have $1,040. If the inflation rate is 6% then the real rate of interest (the interest rate adjusted for inflation) will be negative and your savings will not be able to buy as much as they could have in the previous year. • Effect on interest rates: Commercial banks make their money from charging interest to people who borrow money from them • Effect on international competitiveness: If a country has a higher rate of inflation than that of its trading partners then this will make its exports less competitive and will make imports from lower-inflation trading partners more attractive. • Uncertainty: Not only might there be reduced investment due to a fall in the availability of savings and higher nominal interest rates, but firms may be discouraged from investing due to the uncertainty associated with inflation • Labor unrest: This may occur if workers do not feel that their wages and salaries are keeping up with inflation.

What is an inflationary gap? What causes it to happen?

This point is known as above full-employment equilibrium, since the short-run aggregate supply extends past the long-term aggregate supply equilibrium. If there is an increase in aggregate demand, ADI to AD2, due to changes in any of the components of aggregate demand then, in the short run, there will be an increase in output from Yf to Y1 .

Explain three problems involved in the measurement of inflation.

• Measuring inflation using the consumer price index has one main limitation. The basket used in any country represents the purchasing habits of a "typical" household, but this will not be applicable to all people. • There may be errors in the collection of data that limit the accuracy of the final results. Because it would be utterly impossible to collect the prices of all items bought by all households in all possible locations, it is necessary to take sample items in a sample of selected cities and a sample of selected outlets. • Statisticians try to take into account changes in consumption habits by making changes to the basket. Items are removed or added to be more representative of the typical household's demand • Countries measure their rate of inflation in different ways and include different components. This can make it problematic to make international comparisons. • Prices may change for a variety of reasons that are not sustained. • The CPI (or RPI) measures changes in consumer prices and is a very important indicator of an economy's health. However, there are other price changes which are important in judging the economic health and prospects of a country.

What are the demand side cures for inflation? Explain.

• Monetary policies, which cause an increase in interest rates therefore brining down the aggregate demand. • Fiscal policies, which cause increasing taxation and lowering government spending bringing aggregate demand down.

What are the supply side cures for inflation? Explain.

• Policies to increase the total supply of goods and services by an economy. This brings the aggregate supply to the right, fixing cost push inflation. • Direct controls over prices and wages by the government. There were last used during the 1970s and early 80s in the UK, although they were very much out of fashion as they involve direct government intervention in the markets.