Inflation and deflation

CONTENTS Part 1

1. Inflation
2. Measuring Inflation
3. The CPI versus the RPI
4. Demand-pull inflation
5. Aggregate demand and inflation
6. Causes of demand-pull inflation
7. Cost push inflation
8. Causes of cost push inflation
9. The consequences of inflation
10. Benefits of inflation
11. Effects of inflation

Part 2

1. Deflation
2. Good deflation
3. Bad deflation
 Inflation

Inflation is the name given to an increase in price levels generally. It is also manifest in
the decline in the purchasing power of money

Inflation does not mean that the price of every good and service increases, but that
on average the prices are rising.

Inflation reduces the value of money

Governments aim to control inflation because it reduces the value of money and
the spending power of households, governments and firms.

Creeping inflation

A low and stable rate, of for instance 2%, is generally regarded not to be a problem.
Indeed, seeing a low and steady rise in prices may encourage firms to produce
more. Such a rate of inflation is sometimes known as creeping inflation.

Hyperinflation.

Hyperinflation is a term to describe rapid, excessive, and out-of-control general

price increases in an economy. This is often taken to be an inflation rate that
exceeds 50%

Nominal prices

Nominal prices are simply money prices, which can change over time due to
inflation

Real prices

In contrast, real prices have been adjusted for inflation.

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 Measuring Inflation
Measurement of inflation

Inflation erodes the real value of money. In order to measure changes in the real value of
money as a single figure, we need to group all goods and services into a single price index.

Consumer price index

A consumer price index is based on a chosen 'basket' of items which consumers purchase. A
weighting is decided for each item according to the average spending on the item by consumers

Stages in constructing consumer price indices.

Selecting a base year:

This is usually a relatively standard year in which nothing unusual has occurred. It is given a
value of 100. The base year is changed on a regular basis.

Carrying out a survey to find people’s spending patterns:

A sample of the population’s households are asked to keep a record of what they buy. The
products purchased are placed into categories such as food and clothing and footwear.

Attaching weights to the different categories:

Weights are based on the proportion of total expenditure spent on the different categories. For
instance, if on average households spend $500 of their total expenditure of $2,000 on food, the
category will be given a weight of ¼ or 25%.

Finding out price changes:

Prices in a range of retail outlets and from a number of other sources such as gas companies
and train companies are recorded.

Multiplying weights by price changes:

The total will give the change in the consumer price index but it can go much higher.

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 The CPI versus the RPI

The CPI versus the RPI

Both the consumer price index and the retail price index (RPI ) can be used to calculate the
rate of inflation.

There are three key differences to these price indices:

The items included in the calculations

The main difference is that the RPI includes the cost of housing, such as mortgage interest
payments and other housing costs. The RPI also includes overseas expenditure by domestic.
households. The CPI includes costs paid for financial services.

The population base

Both price indices try to measure changes in the cost of living for the average household.
However, the RPI excludes low-income pensioner households and very high-income
households, as it is argued that these do not represent the 'average' household or the
expenditure of the average family.

The method of calculation

The RPI is calculated using the arithmetic mean whereas the CPI uses the geometric mean.
What this means is that the RPI tends to be lower than the CPI (unless interest rates for
mortgage repayments are extremely low).

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 Demand-pull inflation

Demand-pull inflation is caused by higher levels of aggregate demand driving

up the general price level of goods and services.

Demand-pull inflation is shown by a rightward shift of the aggregate

demand curve from AD to AD1.

This will raise national income from Y to Y1 and force up the general price
level from P to P1.

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Aggregate demand and inflation

A rise in aggregate demand will have a greater impact on the price level, the closer the
economy comes to full capacity.

AD0 to AD1

The figure above shows that when aggregate demand shifts from AD0 to AD1, output can be
raised from Y0 toY1 without increasing the price level.

This is because when output and hence employment are low, firms can attract more
resources without raising their prices. There is time for input prices to change but, due to the
low level of aggregate demand, they do not. For example, when unemployment is high, the
offer of a job may be sufficient to attract new workers.

AD1 to AD2

When the aggregate demand curve shifts from AD1 to AD2, firms begin to experience
shortages of inputs and bid up wages, raw material prices and the price of capital equipment.
The price level thus rises from P1 to P2.

AD2 to AD3

As output reaches Y2, the economy is producing the maximum output it can make with
existing resources. When aggregate demand shifts from AD2 to AD3 , there is a price rise
from P2 to P3, inflation becomes a problem. Additional increases in demand lead to higher
prices than output.

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Causes of demand-pull inflation

Demand-pull inflation is caused by higher levels of aggregate demand driving

up the general price level of goods and services.

Increases in aggregate demand may result from:

a consumer boom
a rise in government spending
higher business confidence
an increase in investment
an increase in net exports.

Increase in money supply

Monetarists argue that the key cause of higher aggregate demand is increases
in the money supply. They suggest that if the money supply grows more
rapidly than output, the greater supply of money will drive up the price level.

Imported inflation

Imported inflation occurs due to higher import prices, forcing up costs of

production and therefore causing domestic inflation.

A cut in interest rates

A cut in interest rates causes a rise in consumer spending and higher

investment. This boost to demand causes a rise in aggregate demand and
inflationary pressures.

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 Cost push inflation

Cost-push inflation is caused by higher costs of production, which makes firms raise
their prices in order to maintain their profit margins.

For example, higher raw material costs, increased wages and soaring rents...

...shift the aggregate supply curve for the economy to the left from AS to AS1.

This will force up the general price level from P to P1

This will reduce national income from Y to Y1

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 Causes of cost push inflation

Cost-push inflation occurs where the costs of factors of production rise

regardless of whether or not they are in short supply.

Higher costs

Rises in costs may originate from a number of different sources, such as

Trade unions pushing up wages

Firms with monopoly power raising prices in order to increase their profits
Increases in international commodity prices
Increases in real material costs and fuel perhaps caused by a fall in the
exchange rate can push up prices

Wage price spiral

Higher wages can cause a wage-price spiral. Workers gain a wage rise,
which causes prices to increase, then workers seek higher wages to restore
their real value and so on.

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 The consequences of inflation
The consequences of inflation

A reduction in net exports:

If a country has a higher rate of inflation than its major trading partners, its exports will become
relatively expensive and imports relatively cheap. As a result, the balance of trade will suffer,
affecting employment in exporting industries and in industries producing import-substitutes.
Eventually, the exchange rate will be affected.

An unplanned redistribution of income.

People on fixed incomes (such as students or pensioners) may find themselves worse off, as
their income will not rise even though the cost of goods has increased.

If the rate of interest does not rise in line with inflation, borrowers will gain and lenders (savers)
will lose. This is because borrowers will pay back less in real terms and lenders will receive less.

Menu costs: Inflation impacts on the prices charged by firms.

Catalogues, price lists and menus have to be updated regularly and this is costly to businesses.
Of course, workers also have to be paid for the time they take to reprice goods and services.

Shoe leather costs:

Inflation causes fluctuations in price levels, so customers spend more time searching for the
best deals.

Fall in purchasing power.

As the cost of living increases, consumers need more money to buy the same amount of goods
and services. Consumer confidence may be damaged due to uncertainty in the future prices of
goods and services. Employees will push for higher pay rises, in order to match price rises.

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 Benefits of inflation
The potential benefits of inflation include:

Stimulating output:

A low and stable inflation rate caused by increasing demand may make
firms feel optimistic about the future. In addition, if prices rise by more
than costs, profits will increase, which will provide funds for investment.

Reduce the burden of debt:

Real interest rates may fall due to inflation or may even become negative.
This is because nominal interest rates do not tend to rise in line with
inflation. As a result, debt burdens may fall.

For example, those who have borrowed money to buy a house may
experience a fall in their mortgage payments in real terms.

A reduction in the debt burden may stimulate consumer expenditure

This could lead to higher output and employment.

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 Effects of inflation

The effects of inflation depend on:

The cause of inflation

Demand-pull inflation is likely to be less harmful than cost-push inflation.

Demand-pull inflation is associated with rising output whereas cost-push inflation
is associated with falling output.

The rate of inflation

A high rate of inflation is likely to cause more damage than a low rate. Situations
of hyperinflation usually accompany a major economic collapse featuring high
unemployment and a major decrease in the production of goods and services.

Whether the inflation rate is accelerating or stable

An accelerating inflation rate, and indeed even a fluctuating inflation rate, will
cause uncertainty and may discourage firms from undertaking investment.

Whether the rate is the one that has been expected

Unanticipated inflation, which occurs when the inflation rate was different from
that expected, can also create uncertainty and so can discourage some consumer
expenditure and investment.

How the rate compares with that of other countries.

It is possible for a country to have a relatively high rate of inflation but if it is

below that of rival trading partners, its products may become more internationally
competitive.

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MAKE A MINDMAP

Causes
RPI

CPI Effect
Inflation

Demalnd
Con
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C ost
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 Deflation and disinflation

Deflation

Deflation is defined as a persistent fall in the general price level of goods and services
in the economy - in other words, the inflation rate is negative, for example, –3%.

It results in a rise in the value of money, with each currency unit having greater
purchasing power.

Disinflation

In contrast, disinflation occurs when the inflation rate falls but is still positive.

For instance, the inflation rate may decline from 8% to 6%. In this case, the price
level is still rising but at a slower rate.
 Good deflation

Good deflation occurs as a result of an increase in aggregate supply and will have a
positive impact on the economy.

Good deflation occurs when workers and companies become more productive
and learn to make things at a lower cost.

Advances in technology, for instance, may create new methods of production and
lower costs of production.

This drives down the general price level of goods and services while increasing
national income.

As well as output increasing, employment may rise and the international

competitiveness of the country’s products may increase.

The aggregate supply curve shifts from AS to AS1 pushing down from P to P1. Real
GDP increases from Y to Y1.

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 Bad deflation
Bad deflation takes place when the price level is driven down by a fall in aggregate
demand as shown in the figure below

If people expect falling prices, they may delay purchases since their money will
buy more later. Workers initially resist pay cuts, so employers must lay some off
to cope with falling prices.

Eventually, fear of unemployment persuades workers to accept lower pay. Prices

and wages follow each other down, the mirror image of an inflationary wage-
price spiral.

Deflation is also associated with an increase in interest rates, which will cause an
increase in the real value of debt. As a result, consumers are likely to defer their
spending.

The aggregate demand curve shifts from AD to AD1 pushing down from P to P1.
Real GDP falls from Y to Y1.

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MAKE A MINDMAP

Deflation

Good n def Bad

deflatio lati
on