4.3 Inflation

How is inflation measured?

- The price level is measured in the form of an index. E.g. price index is 100 in 2015 and 110 in 2016 → inflate rate is 10% - Inflation and change in price level can be measured using Consumer Price Index (CPI) and Retail Price Index (RPI)

Link inflation to terms of trade

TOT measures the ratio between export price index to import price index. Inflation will make exports more expensive relative to imports, improving TOT. TOT improvement or deterioration may bring both positive and negative impacts.

Define consumer price index

CPI is used to measure the average prices of a basket of goods in the country, and to calculate inflation rate

Define disinflation

Fall in the rate of inflation

Define hyperinflation

Inflation levels are very high

Define and explain unanticipated inflation

inflation that is uncertain, unpredicted or unexpected Brings far greater costs than anticipated inflation. - Unexpected --> it is forecasted incorrectly - basically write about disadv of inflation

Define rate of inflation

rate of change in average prices in an economy over a given period of time

Define deflation

sustained fall in general price level.

Define inflation

sustained/continuous rise in price level in an economy over time

Describe the causes of deflation (with diagrams!)

1) Benign deflation (supply-side) - Generally positive and non-threatening deflation - Caused by an outward shift of the LRAS curve, meaning that the country got a rise in its productive potential. - The economy is able to produce more now, thus boosting national output and employment, without an increase in the general price level 2) Malign deflation (supply-side) - Generally harmful to the economy - Due to a decline in AD for g/s, often associated with an economic recession and rising levels of unemployment

Describe the vicious cycle of deflation

1) Consumers delay spending, waiting for prices to fall further 2) Stocks of unsold goods accumulate so firms cut their prices, profit fall 3) Firms cut their production and reduce the size of their workforce 4) Household incomes fall as unemployment rises, reducing demand further

Link inflation to unemployment

Conflict of macro-economic aims (trade-off) However, achieving long-run economic growth (shift in LRAS) can help to maintain low inflation and unemployment.

Define creeping inflation

Prices rise a few % on average each year

Evaluate - comparing inflation and deflation

Rate of inflation Causes of deflation **Conclusion** Overall, mild and stable inflation is preferable

Describe the consequences of malign deflation

1) Cyclical unemployment - Deflation is associated with a fall in AD, which causes a fall in the derived demand for labour. 2) Bankruptcies - Consumers tend to spend less during deflation, so firms suffer from lower sales revenues and profits. - As it is more difficult to pay their costs and liabilities, firms may be forced to close down. 3) Lower investment expenditure - Firms have less incentive to invest due to their lower prices and hence profitability. - This discourages investment and leads to lower economic growth. 4) Rise in the real value of debts - The real costs of debts (borrowing) increases when there is deflation because real interest rates rise when the price level falls. 5) Fall in the value of wealth - Due to declining profitability, share prices fall during times of deflation. - This means that dividends and the capital returns on holding shares also fall, reducing the wealth of shareholders 6) Govt debt - With more bankruptcies, unemployment and lower levels of economic activity, tax revenues fall whilst the amount of govt spending rises. - This can create a budget deficit for the govt. 7) Declining confidence levels - With deflation and the subsequent rising value of debts, both consumers and businesses' confidence levels fall. - This accentuates the economic problems in the country - consumers may postpone their spending and firms postpone their investments.

Describe the causes of inflation

1) Demand-pull inflation (DPI) - Occurs when there is excessive demand in the economy (AD rises at a faster rate compared to AS), leading to a positive output gap (actual GDP > potential GDP) - When there is excess demand, producers can raise their prices and thereby achieve greater profit margins DPI is most likely when there is full employment of resources, or when aggregate supply is inelastic. - Excessive demand can be caused by: a) Excessive rise in consumer spending b) Substantial increase in spending by firms perhaps in response to large increases in demand from consumers. c) Increase govt spending / decrease in taxes d) Boom in the world economy (causing rise in global demand for exports) 2) Cost-push inflation - Occurs due to rising costs which lead to changes in the aggregate supply of an economy - Firms may shift the burden of the increase in production costs to consumers (depending on the elasticity of demand) to maintain their profit margin, leading to a rise in price level - Major sources of increased cost: a) Rise in wage costs b) Rise in import prices c) Firms increase prices to increase profits d) Govt raises indirect tax rates or reduce subsidies, thus increasing prices 3) Monetary inflation - Occurs when the Central Bank prints more money, increasing money supply in the economy - There are more money chasing the same amount of goods and services, causing a rise in price level - Real value of money drops, enticing firms to increase their prices and hence maintain the real value of their profits - Interest rate falls, exchange rate falls 4) Imported inflation - Occurs due to increases in the prices of imports, which may have been caused by a rise in foreign prices or depreciation of a country's exchange rate. - Increases the prices of: a) Imported final products b) Imported raw materials that increase domestic costs of production, which leads to increases in the prices of domestically produced goods.

Describe the uses of price indices

1) Economic indicator - A CPI measures the price inflation, and therefore a measure of changes in the cost of living 2) Price deflator - Rising prices reduce the purchasing power of wages, profits, pensions, savings, tax revenues and a host of other economic variables of importance to different groups of people and decision makers - A price index is therefore used to calculate changes in their real values over time 3) For indexation - Indexation involves increasing certain payments and values, such as state pensions and income tax thresholds, by the annual rate of increase in price inflation in order to keep their real value constant

Benefits of inflation (low and stable)

1) Promotes the efficient use of productive resources - When inflation is high, a substantial quantity of an individual's time and resources from the economy are spent on searching for mechanisms to defend themselves from inflation - E.g. businesses have to channel more resources into portfolio management in order to avoid financial losses - This is an efficient use of productive resources that do not generate wealth to society (time loss - shoe leather costs) 2) Reduces uncertainty - Low and stable inflation creates certainty for businesses and investors - Uncertainty can have negative effects on expected profits from investment, and therefore, negative effects on long term growth 3) Fosters investment and spending - Low and stable inflation is a macroeconomic indicator for stability that contributes greatly to the confidence of people and businesses for making investment decisions - Consumers will not delay their spending but will choose to make the purchase now knowing there will be a rise in price level in the future, thus encouraging firms to produce more 4) Provides arbitrary redistribution of income and wealth - High inflation will particularly affect the poorest sectors of society, as those wage earners and retired people will have very few mechanisms to protect themselves against the inflationary erosion of their income

Describe the steps to calculate CPI

1) Select a base year - No drastic fluctuation / economic event (no war, govt instability) 2) Create a basket of goods - this represents the average spending pattern of each household 3) Collect data from big to small retail stores - This is because the average price of the commodities have changed since the base year 4) Calculate price index for each item - Price index = (current year price / base year price) x 100 5) Calculate assigned weight for each item - Weight = (expenditure on the good/total expenditure) x 100 - This is how much households spend their income on each category of G&S to reflect the relative importance of G&S in consumer spending - E.g. weightage of food may decrease in a basket of goods as it is price inelastic, thus consumers may spend a lower proportion of their income on it as their income rises 6) Calculate weighted index - Weighted index = index x weighted 7) Calculate CPi - CPI = total weighted price index / total weight 8) Calculate rate of inflation - (CPI 2 - CPI 1) / (CPI 1) x 100

Link inflation to balance of trade

BOT = the difference between a country's exports and imports. (the biggest component in CA and BOP) Inflation makes exports less competitive → reduce DD for X → BOT deficit Note: if DD for X is inelastic → inflation will lead to improvement in BOT.

Define deflation

Continuous fall in the price level of an economy over time (negative inflation); also refers to a time where there is a slowdown in the economy's growth rate **FALL IN INFLATION RATE ≠ FALL IN PRICE LEVEL** Fall in inflation rate --- if inflation rate is still positive, price level is rising, just at slower rate.

Define and explain indexation

Economic variables like wages/taxes are increased in line with inflation. Reduces many costs of inflation and reduces pressure on govt to tackle problem of inflation directly, but is NOT A CURE for inflation May hinder govt attempts to reduce inflation because indexation builds in further cost increases

Define and explain anticipated inflation

Inflation that is expected, predicted or known. It is better to have expected the rate of inflation when it comes to individual, businesses and govt planning, as economic agents can take steps to mitigate the effects of inflation through indexation - appropriate policies can be planned or identified and implemented to offset or tackle the potential inflation. - easier to plan --> foreign / local investors, export buyers, lenders and savers - indexation can be done --> govt can adjust certain payments and values, e.g. transfer payments, taxation etc to maintain the real value of pensions and disposable incomes

Link inflation to exchange rate

Inflation → prices rise → losing international competitiveness → DD for exports fall → DD for currency fall → ER depreciates LOW ER: - Imported raw materials are more expensive → CPI - Exports are relatively cheaper → DD for exports rises → AD rises → DPI HIGH ER: - Imported raw materials are cheaper → moderating CPI - Exports become more expensive → reduce DD for exports and increase DD for imports → moderating DPI The impacts of inflation on exports and imports will be depending on: - Other countries' inflation rate - The cost of production - The quality of exports - The PED for exports

Consequences of high and fluctuating inflation

LOSERS 1) Fixed income earners (salary workers and pensioners) - As their incomes do not change according to their output level, their real income drops 2) Low income earners - Inflation harms the poorest members of society far more than those on high incomes - Those of the high income group have accumulated wealth and thus are not so affected by higher prices 3) Consumers - The purchasing power of consumers decline as the real value of money drops, leading to rise in cost of living 4) Savers - Real value of savings decline during inflation when interest rates remain unchanged (or are negative) - Unless banks are willing to increase the interest rate to offset the effect of inflation, households/firms/govt are discouraged to save as money becomes less effective as a store of value 5) Lenders (creditors) - Money lent to borrowers are worth less when they repay the loan during inflation - Thus, inflation will distribute income unfairly from lenders to borrowers 6) Exporters - Inflation erodes the international competitiveness of a country's exports. - This causes a fall in demand for exports, lowering export earnings and possibly lower economic growth and unemployment. 7) Firms - Menu costs - added cost for firms to update their catalogues, price lists and menus regularly to accommodate changing prices 8) Govt - If exports are impacted, it will lead to CAD - This affects foreign investments, resulting in BOP deficit WINNERS 1) Borrowers (debtors) - Real value of the debt declines if real interest rates are negative, meaning that they repay less in real term during inflation 2) Workers with strong wage bargaining power - Workers suffer from a fall in real wage during inflation, thus trade unions can argue a case for a pay rise to maintain their real income. - This causes labour costs to rise, lowering firms' profit margin. If the firm does not concede to the trade union's demands, workers may carry out industrial disputes which affect the firm's production.

Evaluate - factors determining severity of inflation in the economy

Rate Duration Anticipated or unanticipated Types of inflation (on output level) Comparison with other countries Whether the country is an exporter or importer

Evaluate - compare inflation and CAD

Rate of inflation Size of deficit If the country is an open or closed economy PED of imports and exports

What is the general effect of inflation?

When a country is experiencing inflation, the real value (internal value) of the country's money will fall, decreasing the purchasing power of money and increasing the cost of living in the country --> causing a fall in standard of living. This makes conditions far less predictable for economic stability. Thus, maintaining a low and stable rate of inflation is always beneficial to an economy.