10.

2 Low and Stable Prices

Low and Stable Prices
 Low and Stable Prices
Success Criteria: I can…
• Distinguish between inflation, disinflation and
deflation
• Explain that inflation / deflation are measured
by CPI
• Explain problems of using CPI
• Explain the purpose of Core inflation
• Explain the PPI
• Construct an Index (HL)
• Calculate inflation from a data set (HL)
 Low and Stable Prices
Success Criteria: I can…

• Distinguish between inflation, disinflation and

deflation
 Low and Stable Prices
• Inflation – is a persistent or continuing rise in the
average price level
• Deflation – is a persistent or continuing fall in the
average price level
• Disinflation – a decrease in the rate of inflation

Deflation is less common than inflation. Japan (the world’s 3rd

largest economy) has suffered from a deflationary recession
for several years – despite near zero interest rates and an
expansionary fiscal policy
 Low and Stable Prices
CONSUMER PRICE INFLATION IN JAPAN

3.5

3.0
Annual Percentage Change in Prices

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Source: OECD, data for 2002 and 2003 is a forecast
 Low and Stable Prices
• Complete price stability means ‘zero’ inflation.
• This could quickly slip into deflation.
• Deflation means that consumers hold back on
spending as tomorrow it might be cheaper. Hence
falling AD.

• Low inflation means keeping inflation at around

2%.
• This is generally seen to be better (see benefits
slide).
 Low and Stable Prices
The benefits of inflation

1. Not really a benefit, but some argue that inflation

is a necessary side-effect of economic growth and
that as long as it is fairly steady, it does not pose a
problem.
2. Inflation makes it possible to save workers from
unemployment through ‘real wage cuts’, i.e. “yes, I
will give you a 2% pay increase” (because I know
that inflation stands at 3.5%).
3. Gives firms some room to manoeuvre with prices.
 Low and Stable Prices
Long Term Inflation Data for the UK
Annual average percentage change in retail prices
Mean Inflation Standard Deviation

1950-59 4.1 1.06

1960-69 3.7 0.72
1970-79 13.1 1.81
1980-92 6.4 1.14
1993-02 2.5 0.21
1950-02 5.9 1.41
Source: Bank of England www.bankofengland.co.uk
 Low and Stable Prices
Success Criteria: I can…

• Explain that inflation / deflation are measured

by CPI
• Construct an Index (HL)
• Calculate inflation from a data set (HL)
 Low and Stable Prices
• The Consumer Price Index (CPI) is used as a measure of the cost of living
of a typical household

• It calculates the value of a basket of goods & services that the typical
household might buy

• The value of the basket of goods (price x quantity) is converted into an

index

• Goods & services will have different weights depending on the relative
amount a typical households spends on the item

• The first year is called the base year. Index value = 100

• The value of the basket can be measured over time and compared to
the base year or previous years
 Low and Stable Prices
Changes to the UK basket in In Out
2003
Food Lettuce Frozen fish in sauce
  Dried potted snack Tinned spaghetti
  Diet-aid drink powder  
Catering Takeaway caffe latte from coffee  
shops
Alcohol Draught premium lager Brown ale
Household goods Flat pack bookcase Vinyl floor covering
Personal goods and services Designer spectacles Battery powered clock
  Dental insurance Silver charm
  Hair gel and Shower gel  
  Slimming clubs  
Motoring expenditure Automatic car wash Lead replacement petrol
Fares and other travel costs Air fares  
Leisure goods Car CD/radio auto-changer Electronic keyboard
Leisure services Golf non-member green fees  
  Horseracing admissions  
 Low and Stable Prices
Measuring Inflation: The 3 Steps
STEP 1: STEP 2: STEP 3:
HOUSEHOLD
SURVEY to find Record price The % change
what families changes of in price for
buy and how selected items each item is
much they from retail then multiplied
spend on outlets as well by its weight -
particular Items as gas, electricity from this the
- this provides and transport average change
the WEIGHTS suppliers every in the CPI is
and the basket month determined.
Low and Stable Prices (HL)
Low and Stable Prices (HL)

97.33
100
102.53
106.18
108.57
 Low and Stable Prices (HL)
Product Weight Price Value Price Value Price Value
2014 2014 2015 2015 2016 2016

A 20 $5 $100 $7 $140 $8 $160

B 50 $23 $1150 $25 $1250 $26 $1300
C 30 $12 $360 $13 $390 $14 $420
Total
Value of - - $1610 - $1780 - $1880
Basket

Weighted - - 100 - 110.56 - 116.77

Index

 
 Low and Stable Prices (HL)

To calculate inflation use the indices.

Later date CPI – Earlier date CPI

Earlier date CPI x 100
 Low and Stable Prices (HL)
CPI What is
Year (weighted index) Inflation Rate happening?

2012 99 -

2013 100 1.01% inflation

2014 105 5% inflation

2015 107 1.9% disinflation

2016 106 -0.93% deflation

 Low and Stable Prices (HL)
A household divides its expenditures as shown.
 
Food Clothing Leisure
50% 40% 10%
 
 The price index for each item of expenditure changes as shown.
Year 0 = 100

Food Clothing Leisure

Year 1 $120 $100 $150
Year 2 $170 $120 $240
 
If the family was typical of all families in the economy what would be
a) the rise in the CPI. b) the rate of inflation (2 dp) from:
i) Year 0 to Year 1 115 = 15%
ii) Year 1 to Year 2 157 = 36.52%
 Low and Stable Prices
Success Criteria: I can…

• Explain problems of using CPI

• Explain the purpose of Core inflation
• Explain the PPI
 Low and Stable Prices
Why can the CPI be misleading as a measure of
inflation?
 
1. All price indexes are weighted averages. Different rates
of inflation can be calculated by changing the weights.
The CPI calculates average prices for an typical
household. Not for pensioner households or one-parent
households. Households different incomes and different
weights. E.g. One major difference between average
households and these two is the % of income spent on
food. Therefore a higher change in price of food will
result in higher rates of inflation for pensioners rather
than the typical household.
 Low and Stable Prices

2. Typical households also differ by region or cultural

group. Their basket of goods would look very different to
the one used

3. As prices rise / fall the law of demand states that we

will buy less / more of the good and more / less of a
substitute. So are actual weightings will change in
response to price changes but the weights in the typical
basket are fixed

4. Increased use of discount stores and factory stores. CPI

measures prices in retail stores.
 Low and Stable Prices
5. The index cannot indicate quality changes.
Product prices may increase because of improvements
to, or changes in, specification not because of inflation

6. The index cannot take into account changes in

spending in that come about because of new products
 
7. Time. Even though the weights are changed the
basket of goods in 1982 is totally different from the
basket in 2012. So how can they be compared?
 Low and Stable Prices
International comparisons.
The CPIs of different countries differ from
each other because they will have different
basket of g&s and different weights.
International comparisons are thus less
accurate.
To address this problem, the EU has devised
a Harmonised Index of Consumer Prices
(HICP).
 Low and Stable Prices

Harmonized Indices of Consumer Prices (HCIP)

 
This allows comparisons to be made across the
members of the EU. Excluded from the index are
housing costs, insurance, health and education.

The index is based also based on the average

household expenditure of the whole population. It
therefore includes the expenditure of high-income
and pensioner households.
 Low and Stable Prices

• Producer Price Index (PPI) – Factory gate prices. It

measures the prices of thousands of finished and
semi-finished goods leaving the producers. It is a
good indicator of future price rises in the CPI as it
measures changing costs.
• Core Inflation – This is the CPI less food and energy
prices. These have a tendency to change rapidly
(volatile) depending on swings in demand and supply.
By removing these from the index economists can
see the underlying inflation
 Low and Stable Prices (HL)

Year GDP deflator Nominal GDP per

Capita
2015 100 $1500
2016 110 $2000

Using a GDP deflator calculate the real

GDP per capita in 2016
 GDP Deflator from 8.3 (HL)

Nominal GDP
Real GDP = ´ 100
GDP Deflator
 Low and Stable Prices (HL)

Year GDP deflator Nominal GDP per

Capita
2015 100 $1500
2016 110 $2000

Using a GDP deflator calculate the real

GDP per capita in 2016

$1818.18
Low and Stable Prices
Low and Stable Prices
 Low and Stable Prices
Success Criteria: I can…

• Discuss the consequences of inflation

• Discuss the consequences of deflation
 More inflation

other Unemployment

Costs of
Inflation

Economic growth Inequality

Balance of Payments

Anticipated Unanticipated
 Low and Stable Prices
The costs or consequences of inflation
1. Redistribution effects
• Consumers and businesses on fixed incomes lose out because the their
real incomes falls. Pensioners and Landlords
• Employees in poor bargaining positions lose out and they tend to be
lowest paid already. Nurses and investment bankers real income gap grows
• Borrowers gain at the expense of savers and lenders because inflation
erodes the real value of existing debts

2. Distortion of normal economic behaviour – as the price level increases

the purchasing power of cash decreases, consumers may start to hoard
consumer goods making demand unpredictable and lacking in stability.
 Low and Stable Prices
3. Uncertainty. Inflation can disrupt business planning and
lead to lower investment. Possibly causes higher
unemployment

4. Slower growth. Rising inflation is associated with higher

interest rates - this reduces economic growth and can lead to
a recession

5. Wage-price spiral. Inflation can get out of control - price

increases lead to higher wage demands as people try to
maintain their living standards. This is known as a wage-price
spiral (diagram)
 Low and Stable Prices
6. International uncompetitiveness – when inflation is
higher in one country than another this increases the
price of exports out of the country

7. Shoe leather costs whereby consumers may have to

spend a long time shopping around to find which firm has
increased prices the least

8. Menu costs – The firm has ‘menu costs’ because they

have to keep changing price tags and brochures etc
 Low and Stable Prices
9. Money illusion. This is the belief that prices are stable
when in fact they are not. e.g. workers receive a 2% wage
increase and believe they are 2% better off. However if
inflation is running at 5% so in fact they are worse off.
Their real wage has fallen. If this is common then
consumers are making wrong choices when they spend

10. Breakdown of the functions of money – money may

cease to become a useful and efficient medium of
exchange. This is especially true where hyperinflation
occurs and money becomes more useful for burning than
spending. Defined as 50% per month.
 Hyperinflation

A Bank of England employee The hyperinflation in Weimar Germany led to

pictured in the 1920s with a 20 employees taking their wages home in larger
million deutschmark note – wicker baskets
whose purchasing power
equated to a box of matches
 Hyperinflation
Zimbabwe 2008
•Prices doubled here every 24.7 hours in November
2008 and inflation reached levels of 79 billion-odd %.
They eventually stopped using the official currency and
switched to the South African Rand or the $US. A loaf
of bread ended up costing $35 million. This is the most
recent case. It was Mugabe’s land-redistribution
program that caused this.
 Low and Stable Prices
Anticipated inflation:
– When people are able to make accurate predictions of inflation, they can take steps
to protect themselves from its effects
– For example, trade unions may exercise their collective bargaining power to
negotiate with employers for increases in money wages so as to protect the real
wages of union members

Unanticipated inflation:
– Unanticipated inflation occurs when economic agents (people, businesses and
governments) make errors in their inflation forecasts
– Actual inflation may end up well below, or significantly above expectations causing
losses in real incomes and a redistribution of income and wealth from one group in
society to another
Low and Stable Prices
 Low and Stable Prices
Consequences / Costs of Deflation
1. Redistribution of Income – Real value of household,
corporate and government debt rises when the price level
is falling. Savers and lenders all gain
2. Financial crises. If the real value of debt increases beyond
which economic agents can sustain (remember this is
happening in a deflationary gap or recession) they will
default and create a bad debt which has a knock on effect
on the banking sector creating a financial crises
3. Uncertainty
4. Menu costs
5. Shoe Leather cost
 Low and Stable Prices
6. The deflationary spiral. Consumers may decide to
postpone consumption if expect prices to fall further in
the future. Firms may delay investment. AD falls, U
Falling asset prices hit personal sector financial wealth
and confidence – leading to further declines in AD, U
Real interest rates will rise if nominal rates of interest do
not fall in line with prices – less C + I. AD falls, U
Company profit margins come under pressure – leading
to higher unemployment as firms seek to reduce costs
 Low and Stable Prices
Price LRAS A decline in AD causes a
contraction in SRAS and
Level SRAS
puts downward
pressure on the price
level. A deflationary gap
exists when real
national output <
potential GDP (Yp). If
PL1 the deflation becomes
persistent then AD2
PL2
falls again to AD3
PL3 creating even more
unemployment at Y2.
Solution: expansionary
demand side policies
AD1
AD 3 AD 2

Y2 Y1 Yp
Real
Deflationary gap GDP
 Low and Stable Prices
Benign Deflation
• If the falling prices are simply the result of improving technology or improved
productivity, and the LRAS shifts right that is good deflation.
• When you make an international telephone call for 3¢ a minute or fly on a low-
cost carrier for THB800 the consumer is getting the benefit of technology in the
form of lower prices
Malign Deflation
• Malign deflation occurs when prices fall because of lack of AD leading to a
deflationary gap, as has been happening in Japan. This bad defaltion

Whether deflation remains benign or becomes nasty depends, to a large

extent, on how people react to it. However, as deflation is seen as worse
than inflation, governments can’t risk consumers and firms reacting to
falling prices (whatever the cause) by reducing spending creating a
deflationary-cyclical unemployment spiral
Low and Stable Prices
 Low and Stable Prices
Success Criteria: I can…

• Explain the types of inflation

• Evaluate policies to deal with inflation
 Low and Stable Prices

Causes of Inflation
There are two basic causes.
• Demand-pull inflation = Increases in AD =
demand-side.
• Cost-push inflation = General rise in the costs
of production = supply-side.
 Low and Stable Prices
• Demand-pull inflation is a rising price level caused by a high
increase (or successive high increases) in AD, shown by a shift in
the AD curve to the right.

• Firms will increase output if the price they receive increases as

they make more profit. The excess demand would encourage
them to expand their output. They may also implement overtime.

• The shift in AD could be made worse if a country is already on its

PPC or at YFe. If this happens then SRAS will need to extend in
the short-run beyond capacity.
 Low and Stable Prices
Main causes of demand-pull inflation
• A depreciation of the exchange rate increases the price of imports and
reduces the foreign price of exports. If consumers buy fewer imports,
while exports grow, AD in will rise
• A reduction in direct taxes. If direct taxes are reduced consumers will
have more disposable income causing demand to rise
• Reduction in interest rates leading to increases in C & I
• Rising consumer confidence
• Increases in wealth perhaps brought on by an increase in the rate of
growth of house prices
• Faster economic growth in other countries – providing a boost to exports
overseas
 Low and Stable Prices
LRAS
General Start at A and
Price Level
SRAS 1 AD increases
causing an
C inflationary gap
at B. According
P2
B to neo-
P1
A classicalist PL
will continue
AD 2
rising until C
AD 1

Yp Y2 Real National Output

 Low and Stable Prices
AD1 to AD2 leads to in
increased prices due to
Price Level AS
ever increasing supply
constraints as full
employment is reached.
Too much spending
P2 chasing too few goods.
No more output possible
beyond full employment
P1 only inflation P1 to P2
AD2

AD1

Y1 Yfe Real National

Output
 Low and Stable Prices

Main causes of cost-push inflation

• During the 1960s and 1970s inflation
increased globally even when there was no
evidence of successive high levels of
aggregate demand.
• Cost-push inflation is a rising price level
caused by an increase in the costs of
production, shown by a shift to the left of the
SRAS curve.
 Low and Stable Prices
• Many cost-push theorists blame monopoly power.
• In the labour markets growing trade union strength
is blamed (especially an issue in the Keynesian era
of the 1960s and 1970s). Especially where wages
were forced above any productivity increases.
• But anything to do with spiralling costs for firms
(aggregate supply shifting to the left) could be a
cause of cost push inflation.
 Low and Stable Prices
Cost-Push is when costs of production are increasing
• Causes:
– External economic shocks (commodity price fluctuations)
– A depreciation in the exchange rate
– Acceleration in wages and earnings as labour market
tightens
• This leads to inward shift in short run aggregate supply curve
• Firms raise prices to protect their profit margins
• Wages often follow prices – an increase in inflation may lead to
a rise in pay claims – this is known as a wage price spiral
• A rise in actual inflation can lead to an increase in inflationary
expectations
Wage-Price Spiral
 Low and Stable Prices
Brent Crude Oil Prices Commodity price fluctuations
Closing daily price, US dollars per barrel of oil
80

70

60

50
USD/Barrel

40

30

20

10
01 02 03 04 05 06
Source: Reuters EcoWin
 Long Run Aggregate Supply
Start at A and
SRAS shifts left.
LRAS SRAS 2 This creates higher
General
Price Level prices as firms try
SRAS 1
to maintain profit
margins by passing
on higher costs by
B raising prices.
P2
Contraction in AD
due to WIFI to point
P1 A B. Output falls and
unemployment
rises.
Danger of a wage
AD
price spiral and
SRAS shifts again
Y3 Yp Real National Output
 Low and Stable Prices

• Stagflation is the combination of a general

rise in prices (inflation) and a fall in RNO or a
fall in the rate of growth of RNO.
• This was what happened globally 1970s.
• In early 2008 many economists feared we
may see a return of stagflation.
Low and Stable Prices
 Low and Stable Prices
Policies
• Supply side policies to shift LRAS outwards (to the
right) can be used against both types of inflation
• Contractionary fiscal and monetary policy can be
used against demand-pull
• Contractionary fiscal and monetary policy can be
used against cost-push but will worsen
unemployment. For cost-push need to know
underlying cause to find right policy. (wages, oil,
monopoly power, imports prices)
Low and Stable Prices
Low and Stable Prices
Paper 3