INFLATION Inflation is the persistent tendency for the general level of prices to rise over a period of time, i.e the price rise must be going on over a period of time. Also “general prices’ as some prices may be rising while a few falling. Deflation is persistent tendency for the general level of prices to fall over a period of time (NOT always a good thing) Governments aim to have inflation under control. A low rate is good for the economy or “creeping rate” as opposed to “runway” or “galloping” inflation or hyperinflation- zero to one percent too low. 2% percent may be okay, some government may accept up to 5%. When inflation raises money losses its value, this could lead to depreciation of the exchange rate so imports more expensive. In 1989 Brazil’s inflation reached 17.5%-hyperinflation. CAUSES OF INFLATION Milton Friedman said “inflation is always and everywhere a monetary phenomenon” (Monetarist). They believe inflation is caused by ‘TOO MUCH MONEY CHASING TOO FEW GOODS”. Irving Fisher. QUANTITY THEORY OF MONEY- Profe equation to explain this theory. 1 Fisher proposed a simple MvV=PT M- amount of money/money supply. V- velocity of circulation, rate at which money changes hands. Je. Money can finance different transactions as it moves from hand to hand-if. $5.00 finances transactions worth $20 then 4 P- is the price level T- no. of transactions taking place in the economy.The right hand side of the equation is the national income and the left hand side is the money supply. The right hand side must be equal to the left hand side because total expenditure must be financed by the total amount in the economy. Next Fisher recognizes that V&T are constants while M&P may change so- MvV=PT If V&T are constants P must vary with M eg. M= $1000 v=4 P=S8 T=500 Thus $1000x4= $8 x500 $4000 = $4000 Suppose the money supply increased to $1500. Vé&T are constant, so what happens toP? $1500x4= Px500- Find P $1500x4=$6000 Px500=$6,000 P=6000/500. =12 So the money supply increased by 50% and prices by 50%. The price level varies in direct proportion to the money supply. So inflation is caused by increases in money supply.INFLATION: DEMAND PL JOHN M.KEYNES) Aggregate demand (AD) is the total expenditure on goods in the economy. AD=C+GH+(x-m) C- Consumption G- Government expenditure [Investment X- exports m- imports If AD increases it will drive prices up,ie. Demand pull inflation, wey R The aggregate supply (AS) shows the total supply in the economy using all factors of production. At AD, price is at P, and no inflationary pressure as the AS curve is perfectly elastic. At AD2, elbow E1 the economy has reached full employment so inflationary pressure begins, prices rise to P2. Then the AS becomes perfectly inelastic so supply cannot increase so any increase in AD will to P3- ie. Demand pull inflation.COST-PUSH INFLATION: As its name suggest is caused by a rise in the cost of production, firms pass on the increase in cost via higher prices. ‘As the AS curve shifts upwards to the left due to the rise in costs, output shrinks from QI to Q2 and prices rise from P1 to P2-eg. Increased wage demands. Elasticity of demand is important if demand is price elastic-it is difficult to pass on prices. Cost push is sometimes called ‘imported inflation’-if factor of production is imported. Eg. Oil. INFLATIONARY SPIRAL: When demand-pull and cost-push interact=inflationary spiral. Hard to tell what started the spiral. Suppose Trade Unions get higher wages> high cost> cost push Employees het higher wages> increase AD> demand pull. Consequences of Inflation Benefits: o Aredistribution of income from those whose incomes are not raising to those whose incomes are rising. In demand pull, goods in shops may rise but costs of it may remain the same- so income is redistributed from suppliers to retailers,© There is also redistribution from lenders to borrowers, as the borrower pays back less in real terms. Eg. If I borrowed $1000 and inflation will lend at interest rate plus inflation. © Tax payers may also pay less taxes in real terms. Problems: © People on fixed income suffer. Eg. Pensioners (have no trade union) o Firms don’t bother to try and cut cost as they pass on extra cost to the customers. © Firms cost can also increase and additional cost to keep changing their costs. Eg. Change “menu” prices. © Hyper-inflation can destroy an economy. Policies to Deal with Inflation: Inflation deals with policies such as: * Monetary policy * Fiscal policy = Supply-side policy Monetary Policy: deals in the control of the supply of money and or rate of interest. It usually is controlled by Central Bank. Money supply- long term measure. Interest Rate-short term measure. ‘There are two tools used by Central Bank to reduce money supply. (a) Monetary Base-All commercial banks must keep deposits in cash at the Central Bank- “ the monetary base/ reserve ratio”. They have to buy law. This reduces the amount of cash they have, so reducing the amount needed or available to give as loans. Of you want to increase cash supply, reduce the ratio if you want to decrease cash supply then increase it. (b) Open Market Operations- This concerns the buying and selling of government bill, bonds etc. If you want to reduce money supply sell these items, if the public buy it they have less to spend, so aggregate demand falls and reduce demand-pull inflation.(c) Interest Rates- Interest is the cost of borrowing or the cost of money. If interest rate increases, cost of borrowing increases, so people borrow less and money supply reduced. A person can either spend or save. Therefore the rate of interest is the opportunity cost of money. The higher the interest rate the greater the cost of holding money for consumption-can be shown on liquidity preference curve which is the demand curve for money. m2 Ms, D \ | QL Suannhy Monew, If the government raises interest rate from rl to r2 demand for money will fall from QI to Q2- so money supply reduced , so demand pull. Only consumption that is affected by interest rate though will be reduced. Eg. Buying a new car. So interest rate affects. CONSUMPTION From C+G+I+ (xm) | Rising interest rate would also affect investment because it is more expensive to borrow. However if investment is interest elastic then interest rate would have a big impact on investment. If it is interest inelastic then a change in interest rate would have no effect on borrowings/investment.Fiscal Policy: controls aggregate demand through taxation and government expenditure (BUDGET) (a) TAXES Direct OR Indirect If direct taxes rise than disposal income falls, money supply falls and demand-pull inflation falls-P.A.Y.E Q \ AN 3 Ne Prices Q & Quantity As income rises consumption rises. Notice even on zero income there is consumption, When direct taxes are increased people consume less so the consumption function shifts downwards from C2 to Cl. Indirect taxes can also reduce consumption eg. Increases in VAT, so reducing demand-pull inflation. But it can also reduce aggregate supply leading to unemployment.(b) Government Expenditure- This is ‘G’ in AD. If government increases expenditure it can lead to inflation if reduced it can be deflationary, but remember cutting government expenditure lead to unemployment. Supply-Side Policies: These are policies designed to influence aggregate supply. If AS increases it can bring prices down. Eg. Of supply-side policies Privatization, cuts cost to maximize profits. - Ending or reducing unemployment benefits so more people seek jobs. - Introducing new technology - Re-training of workers, increase their mobility. Increased education. - Curbing the power of trade unions. ‘These take a longer time to implement and see results,