Download Inflation - Murphonomics

Inflation
One of a government’s key macroeconomic goals is price stability. In other words, a low
and stable rate of inflation.
Definition: Inflation is a situation in which the general price level is persistently
moving upwards.
An extreme form of inflation occurs when prices rise at a phenomenal rate- this is known
as hyperinflation. Under conditions of hyperinflation people lose confidence in money’s
ability to carry out its functions and it becomes unacceptable as a medium of exchange.
Often people are forced to use other tradable commodities such as cigarettes and food (a
_______________ system).
Problems in Measuring Inflation
Inflation is measured by using a ‘basket’ of goods and services that the average consumer
would buy and looking at the changes in price. This method is known as the Consumer
Price Index. However, in practice, there are many practical difficulties for measuring
inflation.
1. There is no such thing as the average consumer as everyone has different
spending patterns. Your parents spending patterns will differ greatly from that of
a rural Chinese farmer. Young people may benefit more from falling prices of
mobile phones and electronic goods relative to old people. Therefore, the basket
of goods may not be representative. Also, as it is updated once a year, it may soon
become outdated for changes in spending habits.
2. Changes in the quality of goods. Changes in the quality of goods mean that price
rises may not reflect inflation, but just the fact it is a different good. For example,
computers have many more features than 10 years ago, so it is difficult to
compare prices because they are effectively different goods. This is similar
situation for many goods such as mobile phones and cars.
3. People have different inflation rates. Rising electricity and gas prices may affect
old people more than young people. Therefore, old people could have a higher
inflation rate than the national average. This is important if ___________ are
fixed because their cost of living may rise as prices rise causing a decrease in
_________ standards.
4. One off shocks may give a misleading impression. For example, a rise in oil
prices will lead to higher inflation. But, this rise in prices may just be temporary.
Tax changes have a similar effect.
As a result of the last problem above economists measure a core/underlying rate of
inflation. This removes price changes of food and energy as these items tend to be the
most ____________.
The Producer Price Index (PPI) measures changes in the prices of factors of production
and this can be useful in predicting future inflation. Why?
Costs of inflation:
1. Loss of _______________ power. If the rate of inflation is 2% this means that
prices of goods and services are rising on average at a rate of 2%. If your income
does not rise by the same amount then you will obviously feel the consequences
and will experience a loss of __________ ___________. Different groups of
people suffer in different ways but in general the following suffer the most:

Those on fixed incomes e.g. _____________, students on government grants,
unemployed and the self employed.

Those in a non-unionised workforce will not be able to bargain for wage increases
in line with inflation, whereas those in strong unions should gain wage increases
at least in line with inflation levels.
2. Those with savings: If you have US$1000 in the bank at 4% annual interest, then
in one year’s time you will have $________. However, if the inflation rate was
6% over the year you will have lost out in real terms as you will not be able to
buy as much now as you could have had a year earlier- inflation discourages
savings
3. Borrowers will gain at the expense of lenders. If US$100 is borrowed at 10%
rate of interest, the borrower will pay back $110 a year later. If the inflation rate
was 12% then the $110 will be worth less than the $100 a year earlier in
_________ terms- the lender has effectively lost out (but the borrower has
gained!!)
4. Effects on foreign trade- A high rate of inflation in, say China, will make make a
Chinese exports ____________________ abroad. In addition, foreign imports
may also become relatively __________________ compared to domestic
produce.
5. Increase in business costs - Extra resources will be directed to cope with
inflation and thus reduce more useful production. Two such costs are menu costs
and shoe-leather costs. Menu costs refer to the need of firms to change price lists
frequently and update publications and shoe-leather costs refer to the time cost of
keeping informed about price changes of a businesses raw materials.
6. Uncertainty and planning - Inflation increases the sense of uncertainty in the
business community. Firms may be discouraged from investing if they find it
difficult to predict their revenues and costs.
Deflation
Deflation is a sustained downward movement in the average level of prices.
It is important that you do not confuse deflation with a falling rate of inflation otherwise
known as disinflation. Most economists believe that disinflation or falling inflation is
beneficial for the economy. A stable price level can lead to better decisions and a more
efficient use of scarce resources. Lower inflation also helps to stabilize inflationary
expectations.
Deflation can be categorized into ‘good deflation’ and ‘bad deflation’
Good deflation occurs when there is a decline in prices after an improvement in
productivity which allows companies to cut costs and prices, thereby raising living
standards. This can be shown on an AD/AS diagram below.
Price
Level
(GDP
Deflator)
Output (Real GDP)
Bad deflation: The type of deflation that analysts fear is the kind that is broadly-based
throughout the economy, long-lasting, and symptomatic of a weak economy stuck in
____________. Bad deflation has its origins in a weak aggregate demand throughout the
economy. This can be shown on an AD/AS diagram below.
Price
Level
(GDP
Deflator)
Output (Real GDP)
When prices are falling, consumers may decide to postpone purchases in the expectation
of buying the item at a cheaper price later on. This causes a fall in demand and can create
further price declines. ________________ will fall as business confidence is low and
profit margins are being squeezed.
Deflation also causes real interest rates to rise, curbing demand. In addition, falling
asset prices (including housing and shares) reduce personal _____________ and inflate
the real value of debt, resulting in higher business failures and personal bankruptcies.