Inflation:

● One of the macroeconomic goals of the government is price stability.

● This can also be expressed as having a low and stable rate of inflation.
● Inflation is a persistent increase of the average price level in an economy.
● Disinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price
level of goods.
● Deflation is a decrease in the general price level of goods and services.
● Hyperinflation is a rapid, excessive, and out-of-control general price increase in an economy.

Important terms:
● Deflation
● Inflation
● Disinflation
● Hyperinflation
● Demand-pull inflation
● Price level
● Cost-push inflation
● Unanticipated inflation
● Anticipated inflation
● Indexation

Demand - Pull Inflation:

● The two main causes of demand-pull inflation are (a) too much demand in the economy, and (b) rising
costs.
● When aggregate demand increases, output increases, and the average price level increases.
● Excess demand could be caused by consumer spending increasing because of low interest rates, or a
very good outlook about the future of the economy.
● Government spending might be too high, or taxes might be too low.
● World demand for the country’s products might be high.
● Another reason for the increase in AD could be because of increases in the money supply.
● When the money supply increases, it encourages people to spend more.
● All of this is because AS is not high enough to balance the increase in Aggregate Demand.
● Inflation due to excess monetary growth:
○ If there is more money in the economy then there will be more spending, and higher aggregate
demand.
○ If the productive capacity in the economy does not grow – if the economy is producing at near full
employment level of output – then the increase in aggregate demand will lead to inflation.

Cost - Push Inflation:

● This type of inflation is caused by an increase in the costs of production.
● This type of inflation will result in a decrease in the level of output, but an increase in the price level.
● Changes in the price of domestic raw materials
● Changes in the costs of labour
● Changes in the price of imported raw materials, capital goods, or components
● A fall in the value of a country’s currency

Demand-pull and cost-push inflation together:

● This is what happens when the economy is near full employment.
● An increase in aggregate demand may lead to spiralling inflation.
● The higher price levels will lead to an increase in the costs of production; such as a rise in wages.
● This will lead to a decrease in aggregate supply, which will lead to a further increase in prices.
● Workers will ask for higher wages, and this may lead to more inflation.
Costs of inflation:
Loss of purchasing power:
● Inflation reduces the purchasing power of people’s income, and will therefore reduce their living
standards.
● If people’s income rises by 2% and the rate of inflation is 4% that means that their real income has
decreased by 2%.
● Their purchasing power has decreased.

Effect on savings:
● Inflation reduces the interest earned on savings. For example, if the interest rate paid on your savings is
4%, and the inflation rate is 2%, then the real interest you have earned is only 2%.

Effect on international competitiveness:

● If a country has a higher rate of inflation compared to its trading partners, then the price of its exports will
rise faster than the exports of other countries.
● Hence, other countries will start to buy less of their exports.

​Uncertainty:
● The uncertainty caused by inflation might force businesses to reduce their investments.
● This has negative consequences for economic growth.

Costs of Deflation:
Unemployment:
● Low aggregate demand means that firms have to lay off their employees. New hiring will also decrease.
● Consumer confidence will decrease because of slow or negative economic growth.
● Unemployed people will not be able to buy products.

Unemployment:
● This will lead to a further decrease in AD, lower growth, and a further increase in unemployment.

Effects on investment:
● Lower prices mean lower rates of profit for firms.
● Firms will decrease their costs and lay off workers.
● Business confidence will decrease, and investments will decrease.
● This will have negative consequences for economic growth.

Costs to debtors (PEOPLE WHO BORROW MONEY):

● Anyone who has borrowed money to make large purchases (such as a house) will see the value of their
debt increase.
● At the same time, the value of their purchases will decrease.
● Many debtors will be forced to default on their loans.
● Businesses borrow money for investment.
● Business confidence will decrease, and investment will decrease.
Reducing inflation:
● ​The appropriate policies to reduce inflation depend on what type of inflation the country is experiencing.
● Demand-pull inflation is caused by excess demand, and therefore the appropriate policies would involve
reducing aggregate demand.
● Cost-push inflation is due to low levels of aggregate supply, and therefore the appropriate measures
would involve increasing aggregate supply.

Reducing Aggregate Demand:

● Contractionary policies to reduce aggregate demand can be divided into fiscal policies and monetary
policies

Fiscal policies to reduce aggregate demand:

● Increasing taxes
○ While the mechanism by which this would reduce aggregate demand is obvious, it is not an easy
policy to pursue.
○ People do not like to pay taxes, and in a democracy any government that increases taxes would
lose popularity and the chance of getting re-elected.
● Lowering government spending
○ Lowering government spending is also difficult, since many people are negatively impacted by a
reduction in government expenditures, and the government would lose support.

Contractionary monetary policy:

● This involves raising interest rates in order to reduce aggregate demand.
● Increasing interest rates would increase the burden on people who have mortgages and other types of
loans.

Increasing Aggregate Supply

● The tackling of cost-push inflation involves the reduction in wages, and reduction in taxes.
● One of the major ways that governments can ensure the slow growth of wages is by tackling inflation
itself. If people have expectations of low inflation, then they will demand lower pay increases, and thus
reduce the costs of labour for firms.

The role of central banks:

● The independence of central banks can help with some of the policy measures that we have talked
about.
● Raising interest rates to tackle demand-pull inflation can upset many segments of the society.
● Governments may be hesitant to take such actions even if they think it would be the right
macroeconomic policy to pursue in order to reduce inflation.
● An independent central bank can raise interest rates when the government in charge does not want to
do so for political reasons.
● The central banks of many countries have explicit inflation targets. They set a specific rate that they try
to maintain, with some allowance for inflation to deviate from this rate.
● Examples include Canada, England, New Zealand, and Poland.
● Some central banks do not have explicit inflation rates that they have officially stated. They have informal
rates that they try to maintain. E.g. The US Federal Reserve.
● The main goal of the central bank is the maintenance of a low and stable rate of inflation.

The dilemma that the government faces

● The government doesn’t always know what is causing inflation.
● If the inflation is cost-push inflation, and the government uses demand-side policies, inflation might come
down, but output would also decrease and unemployment would increase.
● For monetarists who believe that all inflation is always caused by the excess in the money supply, the
solution is easy. The central bank should increase the interest rates and lower AD.
● The trade-off between maintaining low rates of inflation and lowering unemployment creates a major
dilemma for the government.