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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 Also, as it is updated once a year, it may soon become outdated for changes in spending habits. 2.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.