lecture 4: inflation

name a case study of hyperinflation

"Resident Case study" Zimbabwe, where the inflationary rates are so high that the Zimbabwean currency has been rendered more or less obsolete. As a result, since the cost of living has technically been driven up so high that it no longer means anything, combined with a very low GDP per capita, more than 80% of Zimbabweans live in extreme poverty.

how do you calculate CPI

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what is consumer price index(CPI)?

CPI is a measure of the price changes of a representative basket of goods and services consumed by an average household in the country Changes in the CPI therefore represent changes in the cost of living for the average household in the economy, due to a change in the prices of goods and services, particularly essentials.

what is CPI used for by the government?

CPI is used as an interest rate benchmark for governments. High CPI is indicative of very advanced rates of inflation, therefore necessitates the implementation of cool-down measures to relieve inflationary pressures. Done through high interest rates (monetary policy: demand side) to discourage firms and individuals from buying and investing, thus reducing inflation rates. Typically, higher inflation is caused by strong economic growth. If Aggregate Demand in an economy expanded faster than aggregate supply, we would expect to see a higher inflation rate. (Rightward shift of AD curve) If demand is rising faster than supply this suggests that economic growth is higher than the long run sustainable rate of growth. Low CPI is a good thing generally, since purchasing power is not reduced heavily.

why is low inflation a good thing

However, inflation, when controlled, is a good thing, as it brings optimism and a degree of business confidence, where firms are incentivised to invest more, since there are increased profits to be made from increased prices of goods.

define hyperinflation

Hyperinflation is extremely rapid or out of control inflation. Caused by severe economic problems, and sometimes also caused by irresponsible government actions such as excessive printing of money E.g disease, bad crops, malnutrition and therefore a reduction of the labour force etc.

define inflation

Inflation is a sustained rise in the general price level in an economy over time. This does not mean that the price of every good and service increases, but on average the prices are rising. Therefore constitutes a reduction in purchasing power, where GDP remains constant.

why is there a need to control inflation

Inflation reduces the implicit value of the unit of currency, thus decreasing the purchasing power of firms, individuals, households and the government. Therefore causes an increase in the cost of living.

define and describe cost push inflation

caused by an increase in cost of production, leading to firms increasing their prices in order to maintain profit margins prices of goods and services increase, as additional cost of production must be transferred to consumers (draw AD-AS Model -- leftwards shift of AS curve due to shrinkage of production)

benign deflation

caused by higher levels of AS, increasing productive capacity of an economy. causes prices of goods and services to drop, increasing productive capacity of an economy while also increasing national income chinese govt investing in transport and infrastructure, thus improving productivity and output

define and describe demand pull inflation

caused by higher levels of aggregate demand, leading to higher price levels of goods and services results from strong consumer demand occurs when demand outstrips supply, or when supply shrinks or is increasing at a slower rate (e.g.: in hyperinflation, where excessive printing of money combined with scarce supply of goods and services) (draw AD-AS Model)

malign deflation

caused by lower aggregate demand, which cause prices of goods and services to decrease due to excess capacity in the economy. deflation caused by falling demand is extremely detrimental to economy -- decreases expenditure and investment, higher rates of unemployment (structural unemployment) during recession, consumers become more conservative and withhold expenditure, causing AD to drop.

list the consequences of inflation on different groups of ppl and the general effect

consumers ; ppl who save ; ppl with a fixed income ; ppl with low income ; exporters ; importers ; employers inflation can complicate planning and decision making process due to uncertainty whether to spend or invest and increases instability of the economy

decrease in consumer confidence as a consequence of malign deflation

consumers fear that things will get worse for the economy. thus they may postpone their spendings, esp on consumer durable products (like cars and furniture) as they expect prices to fall even further / wait for economy to improve. this does not help economy to improve, causing a downward deflationary spiral

unemployment as a consequence of malign deflation

deflation occur due to falls in AD, this causes a fall in demand for labour

list the different causes of inflation

demand pull inflation ; cost push inflation ; irresponsible increase in money supply ; imported inflation ; increase access to loan

impact on exporters

domestic inflation reduces the international competitiveness of a country. cost push inflation increases cost of production, leading to an increase in cost that must be transferred to the buyer. in the long run, higher prices makes firms less price competitive, causing a drop in profits leads to fall in export earnings, lower economic growth, higher unemployment

how to control inflation

done by limiting factors that cause demand pull or cost push inflation. (e.g.: increase interest rates to reduce consumption, creation of free trade zones to reduce cost of production)

bankruptcy as a consequence of malign deflation

during periods of deflation, consumers spend less so firms tend to lower sales revenue and profits. this makes it more difficult for firms to repay their costs and liabilities.

anything that affects productive capacity of economy

e.g. natural disasters. affects productive capacity of economy, driving down production and national income in an economic slowdown. decrease in national income then causes consumer expenditure to drop as ppl become more conservative, leading to malign deflation.

impact on fixed income earners

fixed income earners (pensioners, salaried workers whose pay do not change with their level of output) see a fall in their real income during inflation purchasing power of fixed income declines with higher prices.

impact on importers

imports become more expensive due to decline in purchasing power. essential imports and raw materials can cause imported inflation. thus, inflation causes problems for countries without natural resources.

increased access to loan

incentivises expenditure

impact on low income earners

inflation affects the poorest members of society more than those with high income . low income earners tend to have high price elasticity of demand, and a slightest increase in cost of goods and services may not be affordable for these people. in contrast, those with higher incomes are not so affected. their wealth serves as a buffer to protect them from inflation

impact on ppl who save

lose out due to inflation as money they saved is worth less than before. creates an incentive to spend more when implicit value of money is still high --> contributes to demand pull inflation less savings means less available funds to invest, leading to lower investment rates

list the causes of deflation

malign deflation ; benign deflation ; anything that affects productive capacity of economy

define deflation

persistent fall in general price level within an economy , opposite of inflation

consequence of benign deflation

positive impact increases productive capacity, boosting production, national income and employment without causing an increase in general price level. boosts economic competitiveness of a country HOWEVER, low prices will not stay low for a long time since AD will increase eventually (increased demand and consumer expenditure when prices are low). there is an increase in national income and economic growth will occur due to higher levels of expenditure Supply side policy (e.g. education) all help to raise national income and lower prices in the long run

impact on consumers

purchasing power decreases. causes a fall in real income as value of money decreases. increases cost of living, consumers will need more money to buy the same amount of goods and services .

Irresponsible increase in money supply

such as excessive and irresponsible printing of money by governments

list consequences of malign deflation

unemployment ; bankruptcies ; govt debt ; decrease in consumer confidence

imported inflation

when price of imported goods (and imported raw materials) increases, leading to an increase in cost of production for companies using these raw materials in production of finished product

govt debt as a consequence of malign deflation

with more bankruptcies, unemployment and lower levels of economic activity, tax revenue decreases (due to economic decline associated with malign deflation). amount of govt spending rises (welfare benefits). this creates a budget deficient for the government as that it needs to borrow money even though the real cost of borrowing rises with deflation.

impact on employers

workers are more likely to demand a pay rise during inflation to maintain their level of real income. as a result, labour cost rises, and profit margins fall, ceteris paribus (cost push inflation) those in highly skilled professions (e.g. doctors) are in strong bargaining position as their skill are in short supply and high demand may create a wage-price spiral, where demand for higher wages to keep in line with inflation simply causes inflation