Download 17 Low and Stable inflation

Low and Stable rate of inflation
IB Economics
Inflation
Inflation is what?
A persistent rise in average
prices in the economy (learn
this!!)
How is it measured?
Normally using the CPI –
Consumer Price Index
What is the inflation target?
Depends on the country
The UK is 2% CPI
Watch inflation video
Show how prices have
changed over the years
Inflation – a
persistent increase in
the average price
level in the economy
usually measured with
the CPI (Consumer
Price Index)
Why worry about inflation?
There are a significant number of
negative consequences associated
with high levels of inflation
Loss of purchasing power
 If the rate of inflation is 2% the
average price of all goods and
services in the economy has
risen by 2%
 If your salary/wages stays the
same then it means you can
buy less goods and services
 Your purchasing power (the
amount you can buy) has
been reduced
 In this case we say that you
have had a fall in real income
(income adjusted for inflation)
Why worry about inflation?
Loss of purchasing power
 If your income was linked to the
inflation rate you would automatically
get a 2% cost of living increase which
means your real income has remained
the same
 If you worked for a company that had
a strong union this may be the case
but lots of people do not have inflation
linked incomes
Self employed, weak trade unions,
fixed incomes (old people on
pensions/unemployed on benefits)
Expected rates of inflation are
important
If your company expects 1.5%
inflation and gives you an increase
of 1.5% but then the inflation rate
turns out to be 2% your purchasing
power will have reduced
Why worry about inflation?
Effect on saving
 If you save $1000 in the bank at 4% annual
interest you will end up with $1,040
 If the inflation rate is 6% then the real rate
of interest (the interest rate adjusted for
inflation) will be negative (4% - 6% = -2%)
 Your savings will not buy as much as they
did the year before
 You would have been better to spend it
than save it
 You will have lost purchasing power
 Inflation therefore discourages saving
 People will buy assets such as houses or
art which will be worth more
 As the bank uses savings to lend to others
– less saving will mean less funds for
investment
 This may have negative implications for
growth
Why worry about inflation?
Effect on Interest Rates
 Commercial banks make money
from charging interest to people who
borrow money
 If there is a high rate of inflation
banks will raise their interest rates to
keep the real rate that they earn
positive
 Effect on international
competitiveness
 If a country has a higher rate of
inflation than its trading partners its
exports will be less competitive
 Imports from lower-inflation countries
will be more attractive
 This may worsen the balance of
payments
 This could lead to unemployment in
export industries and industries that
compete with imports
Deflation
There is good deflation and
bad deflation
 Good deflation
 This comes about from the
LRAS shifting
 Output will increase and
price levels with fall
 This assumes that AD
remains (ceteris paribus)
 This will also give a lower
level of unemployment
(derived demand for
labour from the increased
demand for goods and
services
Deflation – a
persistent fall in the
average price level in
the economy usually
measured with the
CPI (Consumer Price
Index)
Deflation
 Bad deflation
 This comes about from AD shifting
 A downwards shift of AD will result in
lower price levels but also lower
output (less growth)
 This could lead to an increase in
unemployment
 Demand for goods and services will
decrease
 Labour is a derived demand
 If people think prices will go down
they will put off consumption
 When they see prices fall this will
confirm their thoughts
 They will further put off consumption
and AD will keep falling
Deflation
 Japan has a problem with deflation
 Banks collapsed due to bad debts and
bad investments in their own stock
market
 People built up precautionary savings
in case they lost their jobs
 This depressed consumption and AD
 Interest rates were cut to 0.25% but it
didn’t work
 The damage had been done
 Consumer and business confidence
crumbled with people and firms
reluctant to spend
 Don’t confuse deflation with a falling
rate of inflation (this is called
disinflation)
Deflation/Disinflation
 From 1999 to 2000 the inflation rate
rose from 1.2% to 1.6%
 From 2000 to 2001 the inflation rate
fell from 1.6% to 1.3%
 the average level of prices rose
but at a lower rate than the
previous year – disinflation
 In the next two years the inflation rate
continued to fall (prices were still
rising but by a smaller and smaller
amount)
 In 2004 the country started to
experience deflation (the average
level of prices fell by 0.5%)
 From 2004 to 2005 the country was
still in a period of deflation where
average prices fell by 0.3%
Do you understand?
 Which period of time did Japan experience
a) Inflation
b) Disinflation
c) deflation
Costs of Deflation
 Although consumers may be pleased with falling
prices there are many problems with deflation
 Deflation is also a bit of an unknown so it is more
difficult to deal with than inflation
 Some economists argue that the costs of deflation
are higher than inflation
 Unemployment
 If AD is low businesses may lay off workers
 If prices fall consumers will put off purchasing
 Firms will have to drop prices to encourage
consumption
 Consumers will again put of purchasing believing
that prices will fall further (deferred consumption)
 Consumer confidence drops further depressing AD
 This is known as a deflationary spiral
 Investment will also be put off
Costs of Deflation
 Costs to debtors
 Anyone who has taken
a loan (including house
buyers who have taken
a mortgage) suffers
from deflation because
the value of their debt
rises
 If profits are low
businesses will find it
difficult to pay back
loans
 There may be many
bankruptcies
 This will make business
confidence even worse
Play Japan
Inflation video
Measuring Inflation - The Consumer
Price Index (CPI)
 The CPI is a weighted price
index used to measure the
change in the prices of a typical
basket of goods and services
 The contents of the basket are
changed each year
 In the UK they use information
from the Family expenditure
Survey
 Changes in weighting reflects
changes in spending behaviour
(the more that is spent the higher
the weighting)
 In 2008 fruit smoothies, muffins
and USBs were included in the
basket
Family Expenditure Survey: a
 Microwaves, 35mm camera film representative monthly survey of UK
and CD singles were removed household expenditure used to derive
changes in the CPI
Limitations of the consumer price index as a measure of inflation
 Different population groups experience different rates of inflation
 The CPI is an average household and not representative of individual
households
 The weighting for tobacco or motoring expenses will be irrelevant for
non smokers and those without a car
 The CPI does not include house prices
 Mortgage prices will be a high proportion of spend of younger house
buyers
 Many older home owners will have paid off their mortgages
 The CPI may overestimate inflation
 Price rises may hide improvements in the quality of goods and services
 Cars and electrical goods may have gone up in price but this is due to
new innovations
Causes of inflation
 Inflation comes from several
sources
 It can come directly from the
domestic economy
 Price strategies of leading food
retailers based on the strength of
demand or competitive pressures
 A rise in VAT cause firm’s
production costs to go up and these
being passed onto the consumer
 It can come from external
sources
 Increase in price of crude oil or
other imported commodities,
foodstuffs and beverages
 Changes in exchange rates
 A falling pound against the Euro
might cause higher import prices
(remember WIDEC?)
Causes of inflation
 There are 3 main types of inflation
that are caused by different things
a) Demand pull inflation
b) Cost push inflation
c) Excess monetary growth
 As the name suggests demand pull
inflation is caused by an increase
demand (AD)
 Most likely to occur when there
is little spare capacity in the
economy
 Increase in AD will lead to an
increase in prices
 When does AD increase?
 When one or more of the
components increases
 Draw a diagram illustrating demand
pull
Causes of inflation
 Cost push inflation occurs as a
result of an increase in the costs
of production
 Any increase in a firm’s costs
pushes the supply curve up
 If the cost of an input such as oil
that affects the costs of all
business in the economy
increases the SRAS will shift
upwards
 Things that cause production
costs to go up and force firms to
raise their prices to maintain profit
margins
 A rise in costs of imported raw
materials (e.g. by a fall in the
value of the country’s currency)
 Rising labour costs
 Higher indirect taxes
 Wage price spirals
Causes of inflation
 Cost push and demand pull
together
 Let’s say house prices rise and
the wealth effect comes into play
 The economy has little spare
capacity (it is working close to full
employment)
 Consumption increases
 aggregate demand increases
capacity causing demand pull
inflation (1)
 workers will demand higher
wages to help them keep their
current standard of living
 This demand for higher wages
will cause cost push inflation (2)
 Higher wages may also give
households the illusion that they
have more money
 This will further increase
consumption and increase AD (3)
Causes of inflation
 Excess monetary growth
 Monetarists (a branch of new classical
economists) believe that inflation is
caused by excessive increases in
money supply
 If there is more money in the economy
there will be higher spending
 AD will increase
 Because this is a new classical theory
we draw the LRAS vertical
 Increasing money supply (quantitative
easing) tends to be a policy of last
resort
 In the UK the Bank of England has
recently (2012) decided on a policy of
QE because the low interest rates
were not encouraging consumption
 They believe it is safe to do this
because there is spare capacity in the
economy but are watching the
outcome carefully
Milton Friedman (1912-2006) was
a Monetarist who passionately
believed that government
intervention always causes more
harm than good
Reducing inflation
 The appropriate policy depends on the cause
of inflation
 If the cause is the price of oil then this is an
external factor which is out of government’s
control
 If it is demand pull inflation government can
try to dampen demand using
deflationary/contractionary fiscal or monetary
policy
 Evaluation
 There are often problems with contractionary
policies
 Increasing taxes, reducing government
spending or putting up interest rates are not
popular measures
 There are lags with both fiscal and monetary
policy of 1 to 2 years
 Government spending budgets are developed
over a long period of time and may need
lengthy legislative procedures to make any
changes
Reducing inflation / Evaluation
 Monetary policy will harm some people in the
economy more than others
 Anyone that has a loan or mortgage and
businesses that want to invest
 Any government that is looking to be reelected will be reluctant to use these
measures
 This is one of the reasons that many
developed countries have monetary policy
managed by their central bank which is an
independent body
 The UK MPC need to make sure that
inflation is kept within +/- 1% of 2.5%
otherwise they have to write a letter to the
government explaining why
 The Fed does not have an official target
 It is important that people have faith in the
central bank to keep inflation rates stable
or they will demand higher wages
Reducing inflation / Evaluation
 Nowadays monetary policy is
considered to be the most effective way
of managing AD in the economy
 Interest rates are seen as the best
weapon
 Fiscal policy is not seen as an effective
tool for inflation
 Governments have commitments to the
public so it is very difficult to cut
spending
 Plus any cut in G would take a long
time to have an effect on price levels.
 Supply side policies are used to fix cost
push inflation (as long as it is a
domestic issue)
 It is really difficult to say which bit of
inflation is cost push and which bit is
demand pull so policy makers tend to
use a mix of solutions
Reducing inflation / Evaluation
 The biggest issue with reducing AD
is the loss of output and hence
unemployment
 Potentially there is a trade off
between inflation and
unemployment
 If unemployment is lowered AD will
increase causing inflation
 If inflation is lowered AD will
decrease causing unemployment
 Responsibility for managing AD
might be best left to automatic
stabilizers of fiscal policy and careful
changes in monetary policy carried
out by and independent central bank
HL only
Calculating Inflation
Using index numbers
 This is straight forward if you
can calculate percentage
changes
 This table shows the made up
index of house prices
 2005 is the base year
 In 2006 there is an increase of
8.4% so the index goes up to
108.4
 In 2007 there is an increase of
20% since 2005 so the index is
120.0
 We need to take more care
when working out the
percentage change from 2006
to 2007
 It is not 11.6%
 It is (120-108.4)/108.4 x 100 =
10.7%
 (Difference between the two
years divided by the original
year)
Year
Index
2005
100.0
2006
108.4
2007
120.0
Using index numbers
 When we bring several indices together in a basket we have to
give each one a weighting
 The weighting will depend on the proportion of income that is
spent on that good
 If we take this example on average 40% of income is spent on
housing so it gets a weighting of 0.4
 To work out the weighted index you just multiply the index by the
weight
Category
Index
for year
X
Weight
Index for
year X
times
weight
Index for
year X +1
Weight
Index for year
(X+1) times
weight
Housing
120
0.4
48
130
0.4
52
Foodstuffs
105
0.2
11
105
0.2
11
Travel
120
0.2
24
125
0.2
25
Clothing
120
0.1
12
110
0.1
11
Entertainment
125
0.1
12.5
130
0.1
13
1
112
Totals
107.5
Using index numbers
 To find out the rate of inflation you need to do the following sum
 New index – old index divided by old index
 In this case it would be Index for (X +1) minus Index for X
divided by Index for X
 Multiply by 100 to get the % inflation rate
 (112 – 107.5) / 107.5 = 4.2%
Category
Index
for year
X
Weight
Index for
year X
times
weight
Index for
year X +1
Weight
Index for year
(X+1) times
weight
Housing
120
0.4
48
130
0.4
52
Foodstuffs
105
0.2
11
105
0.2
11
Travel
120
0.2
24
125
0.2
25
Clothing
120
0.1
12
110
0.1
11
Entertainment
125
0.1
12.5
130
0.1
13
1
112
Totals
107.5
Time for you to do some
work!!
For homework do some research on
inflation in your chosen country
SL – P241 1a & b
HL – P242/3 Data Response