4.2.3.3 - Inflation and deflation

A general increase in price level over time

Where the average price level in the economy falls. Negative inflation rate

Falling rate of inflation. Average price level is still rising but at a slower rate.

When the price level is increasing at the same rate for a period of time

Price level is increasing at a higher rate in a time period.

CPI (consumer price index) and RPI (retail price index)

Cost push inflation
Demand pull inflation

Inflation which is caused by rising costs of inputs to production which are passed onto consumers in the form of higher prices.

If wages make up a significant amount of a firm's totals costs then it may lead to an increase in prices. --> Firms would want to protect their profits so they will push increased costs onto consumer

The process by which rising wages cause higher prices, and higher prices cause higher wages.
Firms expect inflation to rise they may increase prices to protect profits

Increase in import costs due to tariffs will lead to increase in price level.

Increase in tax will be pushed onto consumers if the good is an inelastic such as addictive demerit goods leading to higher prices

When demand outpaces the economy's ability to produce goods & services.

A depreciation in exchange rate
Lower taxes
Lower interest rates
Increased growth in export industries

Causes imports to become more expensive as you buy less with the pound and exports to become cheaper. This increases AD

Increase in wages
Expectations of inflation
Increase in indirect taxes
Depreciation in exchange rate
Monopolies

Those on low and fixed incomes are hit the hardest by inflation, due to its regressive effect --> cost of necessities becomes expensive. The purchasing power of money fall
Real value of debt decreases --> If consumers have loans, the value of the repayment will be lower --> amount owed does not increase with inflation

High inflation --> high interest rates → cost of investing is high --> firms save --> This is a leakage
May become less price competitive on a global scale if inflation is high (dependent on other countries)
Unpredictable inflation will reduce firms confidence --> unaware of what their costs will be --> less investment

The government will have to increase the value of the state pension and welfare payments, because the cost of living is increasing.

- Real incomes fall with inflation, so workers will have less disposable income.
- If firms face higher costs, there could be more redundancies when firms try and cut their costs.

Malign, Benign

Deflation caused by an increase in SRAS.
May be due to a decrease in the cost of production. Firms can supply more at a given price level

Demand side caused by reduction in consumption due to low levels of confidence often a sign of a recession.

Prices fall, so people delay consumption as they expect their money will have more purchasing power tomorrow, so AD falls, causing prices to fall.

Holding back on spending
The real value of debt rises with deflation
lower profit margins (may lead to increased unemployment)
lower confidence and increased saving

Caused by too much money chasing too few goods

Money supply Velocity of circulation = price level transactions

MV =PT

Total spending in the economy

Total output in the economy

States that there is inflation if the money supply increases at a faster rate than national income

velocity and transactions is constant

That increasing the money supply causes inflation as consumers have more money to spend. Shifting AD to the right --> firms increase supply creating a positive output gap --> this is inflationary

V & T are volatile as it can change due to changes in people's behaviour in handling their money.
There may be spare capacity --> spare capacity means that increases in AD will help get unemployed resources used in the general economy.
There may be a liquidity trap - interest rates can fall to zero, but people may still save, so an increase in the money supply might not affect inflation

Whether the inflation was anticipated

Generates healthy consumption habits
enables adjustments of wages
Incentivises investment and production
Avoid risk of deflation
Avoid risk of high inflation

Not fully representative (represents expenditure of average household)
Different groups have different spending patterns
The CPI does not take into account the quality of goods (increase in price may also be paired with increased quality)
CPI is slow to incorporate new products