Download Objectives of the chapter - The Good, the Bad and the Economist

Chapter 32 – Inflation
IGCSE2
Objectives of the chapter
•
Define issues of inflation and
deflation using AS-AD.
•
•
Evaluate the effects of inflation on iv.
stakeholders in the economy
Evaluate/discuss: Effects of infl/defl
[winners and losers in the re-distributive
effects of inlf/defl]
i.
Define: inflation, deflation, disinflation
ii.
Describe/outline: causes of infl/deflation
Explain and illustrate demand-pull iii.
and cost-push inflation.
Explain/distinguish/draw: use AS-AD to
explain how infl/deflation arises
v.
•
Define CPI and how to measure
inflation. Knowledge needed of
“weights” but no computation
necessary.
•
Explain How a change in the CPI
means inflation. RPI…is really not
necessary.
•
Distinguish between an increase
in the CPI and an increase in the
RATE of infl.
•
Evaluate govt attempts to lower U
or inflation – we get trade-offs and
secondary effects.
i.
Define: CPI and RPI
ii.
Describe/outline: Cost-push and demand
pull inflation (also “excess money supply”
inflation)
iii.
Explain/distinguish/draw: Use a Phillips
curve to illustrate the infl-U trade-off,
distinguish between falling prices and falling
RATE of infl
iv.
Evaluate/discuss: How can govt lower U
without creating inflation?!
v.
What is inflation?
Inflation:
A general and consistent increase in the average level of prices….using CPI.
If the prices of goods and services are going up generally in the economy over a period of
time, inflation is said to exist.
Deflation:
 Refers to the case where the average level of prices is decreasing through time.
Deflation implies negative inflation rates.

It can also be used to describe a slowdown in the economy (a period where aggregate
demand is falling.
Deflation is not as common as inflation. If the inflation rate is negative then the economy is
suffering from deflation. In January 2006 consumer price changed by 0.8% in Japan. This
means that the average consumer price level had decreased by 0.8% compared to January
2005. Japan was suffering from deflation

Deflation is FAR more damaging than inflation!
o Deflation is often coupled to ↓AD…which creates an expectations-based
(“self re-enforcing feedback loop”) self-fulfilling prophecy
o E.g: “If HHs believe that prices will fall → C↓ → ↓AD → prices fall →
“Aha!” → expectations of falling prices → C↓ → ….etc
o “…I expect ‘A’ to happen…and the very actions I take based on my
expectations cause ‘A’ to happen…” [Japan in 1990s!]
How is inflation measured?
Governments usually measure and monitor the rate of inflation.
Rate of inflation:
The percentage by which the average price level, expressed as a price index, has risen between two
periods. – (IB STUDY GUIDE ECONOMICS)
How does the UK measure inflation?
Consumer price index (CPI):
A measure of the general price level (excluding housing costs); used in the UK and across the
Eurozone.
Retail price index:
A measure of the general price level, which includes house prices and council tax.

In the UK, inflation is measured using the consumer price index (CPI) and the retail price
index (RPI). The government records of 600 goods and services purchased by over 7,000
families every month. An average monthly price is the converted into an index number
therefore allowing comparisons between two different time periods.

Both CPI and RPI are measures of average prices calculated from the same price information.

The main difference between the CPI and the RPI, is that the RPI includes house prices and
council taxes.
What causes inflation?
Inflation is caused by different factors and different economists have different views about them. The
three recognised causes are the Demand-pull inflation, Cost-push inflation and Money supply
inflation.
Demand-pull inflation
It is thought by Keynesians that inflation can be caused by too much demand in the economy.
If aggregate demand increases, there will be an increase in the general price level.
Aggregate demand:
The total demand in the economy. It includes C (consumption), I (investments), G
(government expenditures) and X-M (exports- imports).
So demand- pull inflation can be caused by:




Rising consumer spending fuelled by tax cuts or low interest rates.
Sharp increase in government spending
Rising demand for resources by firms
Booming demand for exports.
Demand-pull inflation is most likely to occur if the economy is close to full employment. As
consumers, businesses, foreigners and government increase their spending levels, total
demand in the economy will begin to rise. If businesses are close to full capacity they will find
it difficult to produce the extra output to meet this demand. Therefore they are likely to
respond by rising prices. In sectors where businesses find it almost impossible to produce
more, and where the increase in demand is at its greatest, prices are likely to rise more sharply.
Cost-push inflation
Another Keynesian theory is that inflation can be caused by rising costs. When businesses are
faced with rising costs they put up their prices to protect their profit margins. As a result
inflation is caused.
These are the possible reasons that causes costs to rise:

In the UK it has been suggested that it is caused by the rising costs of the imported
goods such as oil.
E.g. in the early 1970s the price of imported oil went up by around 400%. After this
inflation in the UK reached heights about 25%.

Another cause is wage increases.
E.g. in the 1970s trade unions put pressure on employers to increase wages.
Employers recovered the extra money paid to workers by increasing prices.

The increase in taxation can cause cost-push inflation.
E.g. in 1979 the government increased VAT from 8% to 15%. This added 5%
inflation to that year. If entrepreneurs try to increase the amount of profit they make
this can also cause push inflation. Raising the selling price can make higher profits.
Money supply inflation
Monetarists believe that there is a strong link between inflation and growth in the money
supply. The money supply is the stock of notes and coins, bank deposits and other financial
assets in the economy.
Money supply inflation is caused when households, firms, and the government borrow more
money from the banks to fund extra spending. This adds to the money supply because there
are now more bank deposits. The extra money lent by the banks creates more demand and
prices are driven up.