Download Economic Study Notes Inflation - The description of inflation

Economic Study Notes
Inflation
- The description of inflation
Individual price rise: Occurs when the price of one particular product rises (due to excess demand, increased
demand, decreased supply)
General price level increase: Occurs when the average level of prices increases i.e. CPI increases
Inflation: An increase in the general price level of goods and services over a period of time
Disinflation: Rate of inflation is falling i.e. price level is increasing at smaller percentage than before
Deflation: Occurs when there is a fall in the average price level
Hyperinflation: Price level rapidly increases – value of the dollar declines
-
The use of economic models
Derived from Equation of Exchange
M x V
=
P
x Q
M: Volume (supply) of money in an economy
V: Velocity of circulation i.e. number of times money exchanges hands in order to finance transactions
P: General price level of an economy
Q: Volume of transactions i.e. GDP
An identity: Three bars indicate the equation is always true because of how the terms have been defined
Money supplied x number of times each dollar circulates the economy must equal the value of GDP (national output)
Crude Quantity Theory of Money
Changes in the supply of money are directly proportionally to price changes (assuming Q and V remain constant)
Increases in M lead to increases in P (inflation)
Sophisticated Quantity Theory of Money
Acknowledges that velocity of circulation (V) and real output (Q) may be variables. Central Bank predicts V to
influence Q by controlling money supply (M)
Limitation:
If V and Q change, then an increase in money supply may change real output while the price level remains
unchanged. Reason = Price rises encourage consumers to spend more (purchasing power of savings is eroded) and
velocity of circulation changes.
Aggregate Demand: Quantity of national output purchased at any given price (national income equivalent)
AD = C + I + G + (X –M)
Aggregate Supply: Real output that all firms are willing to supply at any given price
YF Curve (Full employment): All resources are fully employed and firms are working to full capacity
To extend: New technology and/or new resources discovered
Aggregate Demand Shifts:
- Transfer payments (Increase > Decrease <)
- Contractionary fiscal policy (Budget surplus <)
- Expansionary fiscal policy (Budget deficit >)
- Net Exports (Surplus > Deficit <)
- Net Migration (Gain > Loss <)
- Inflationary expectations >
- Business confidence (Increase investments > vice versa)
- Savings (Increase < Decrease >)
- Interest rates (Increase savings < vice versa)
- NZ Dollar (Appreciates < Depreciates >)
Aggregate Supply Shifts:
- Cost of production (Increases < Decreases >)
- New technology >
- Sales tax (Increases < Decreases >)
- Level of productivity (Increases > Decreases <)
- Cost of raw materials (Increases < Decreases >)
- NZ Dollar (Appreciates > Depreciates < NB: Importing raw materials)
- Level of labour force (Increases > Decreases <)
- Interest rates (Rises = appreciates NZ Dollar vice versa)
-
The causes of inflation
Savings: Sacrifice of present consumption – income not spent
Investment: Capital accumulation or formation of capital goods
Level of savings: Dependent on: disposable income, attitude towards thrift, interest rates
Level of investment: Investment requires borrowing so is dependent on level of savings, business confidence, state
of economy, interest rates
Interest rates: Represents reward for savings OR cost of borrowing
Interest rates rise:
o Households encouraged to save more and spend less – Aggregate demand shifts inwards
o Firms investment will decrease as cost of borrowing has increased – Aggregate supply shifts inwards
o NZ becomes more attractive place to keep money = smaller outflow of NZD = decreased supply to foreign
exchange market = appreciation of NZD
o Overseas investors attracted by NZ returns = increased demand = appreciation of NZD
o Exporters incomes fall – less price competitive, sell less, exchange foreign currency for fewer NZD
o Importers are cheaper – spend fewer NZD to buy imported goods
Interest rates fall:
o Households encouraged to save less (less return) and spend more (easier access to credit) – Aggregate demand
shifts outwards
o Firms investment will increase as cost of borrowing has decreased – Aggregate supply shifts outwards
o NZ becomes less attractive place to keep money = larger outflow of NZD = increased supply to foreign exchange
market = depreciation of NZD
o Exporters incomes increase – more price competitive, sell more, exchange foreign currency for more NZD
o Imports are more expensive – spend more NZD to buy imported goods
Cost-push inflation: Process of rising prices is initiated and sustained by increasing costs
e.g.
Increase in factor of production costs: Increased price of production inputs (e.g. wages) causes Aggregate supply to
shift inwards
Overseas prices: ‘Imported inflation’ – inflation in countries supplying components of production
Depreciating NZD: Increases price of raw materials and thus the price of production inputs
Demand-pull inflation: Consumer demand for goods and services outstrips the economy’s ability to produce them,
putting pressure on prices to rise
e.g.
Expansionary fiscal policy: Government spending exceeds revenue – injection in the circular flow model
Inflationary expectations: If consumers believe the price will rise in the future, they will increase spending now to
offset decreased purchasing power
Depreciating NZD: Increased exports, increased exporters disposable incomes, increased consumption spending
Disposable income/transfer payments: Increases consumption spending vice versa
Business (Trade) Cycle: Describes reoccurring fluctuations in economic activity experienced by most economies over
a number of years
Expansion ----- Boom ----- Recession ----- Trough
Changes due to: business confidence; consumer spending; world events
Boom: Increasing economic activity, unemployment falls, investment takes place, prices rising, AD is high,
government tax revenue increases, profits rise, utilisation of existing resources
Recession: Increasing unemployment, decreasing investment, business failures, output decreasing, two or more
consecutive quarters of negative growth, declining sales, incomes fall, business confidence falls
Trough: Significant unemployment, low business confidence, slowing price rises, very low output
Expansion: Emerge from a recession into a period of economic growth
Boom (Inflation): During a boom inflation will increase
-Shortage of raw materials
-Firms bid scarce resources and workers away from other industries (Cost-push inflation)
-Upward pressure on prices (Demand-pull inflation)
Recession /Trough (Inflation): During a recession/through inflation will fall
-High levels of unemployment
-Firms have spare capacity (idle machines/workers)
-Less pressure on prices = inflation falls
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Impact on firms and households
Firms
Poor planning for the future: Inflation makes business decisions difficult because firms are unsure of what will
happen to prices and costs in the future (Consumers may decrease spending even if their wages maintain purchasing
power)
Investment: Businesses play it safe to avoid profit loss. The opportunity cost of such an attitude towards inflation is
no long-term investment decisions
Costs: if unable to pass increased costs onto consumers – profits may fall, business closures, cut back on
employment and production
Households
Redistribution of real income: Fixed income earners (e.g. pensioners, beneficiaries) are disadvantaged as their
nominal wages are unable to keep up with the rate of inflation – real incomes and subsequent purchasing power will
fall. Individuals whose incomes rise faster than the rate of inflation experience an increase in real incomes
Income distribution becomes more unequal than before inflation.
Speculators increase their real incomes by purchasing assets such as property, gold and antiques which rise faster in
value than the rate of inflation
Savings: The value of savings is eroded as its purchasing power has decreased, discouraging consumers to save. If
the interest rate they receive cannot compensate for the rate of inflation they lose the ability to purchase the same
amount of goods and services
Lenders: Disadvantaged because when the money is borrowed, it will be worth less when repaid on a fixed interest
rate
Borrowers: Advantaged as the repayment of interest and principle is with lower valued money. Inflation reduces the
real amount owed as the purchasing power is eroded. These gains must be weighed against the interest owed
-
Impact on trade and growth
Trade
NZ inflation greater than overseas trading partners:
NZ disadvantaged – Rising domestic production costs, increased local price, and decreased quantity demanded
Exporters disadvantaged - Less price competitiveness overseas (Appreciating NZD)
Importers advantaged – Increased imports (Appreciating NZD)
Increases import payments and decreases export receipts
Leads to a deterioration in the Balance of Payments (Larger deficit / smaller surplus)
NZ inflation less than overseas trading partners:
NZ advantaged – Decreased domestic production costs, decreased local price, increased quantity demanded
Exporters advantaged – More price competitiveness overseas (Depreciating NZD)
Importers disadvantaged– Decreased imports (Depreciating NZD)
Decreases import payments and increased export receipts
Leads to a improvement in the Balance of Payments (Larger surplus / smaller deficit)
Growth
Lower investment: Slower national output. Lower output leads to reduction in new jobs or loss through
reconstruction = increased unemployment
Distortion of price signals: Market fails to allocate resources efficiently
Exporters disposable income: Decreases therefore consumption spending decreases