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 weighted basket of goods 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. Pensioners have different spending habits e.g. heating / bus
travel account for a higher % of their expenditure. Young people will benefit
more from falling prices of mobile phones and electronic goods. 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may soon become outdated for changes in spending habits.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. 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.
4. Which Measure to Use? - CPI, RPI or RPIX. RPI includes mortgage interest
payments. CPI doesn't. In 2009, with falling interest rates, RPI gave a negative
inflation rate, whilst CPI was positive. Therefore, it is important which measure is
used. The U.S. government's preferred measure is currently CPI.
5. People have different inflation rates. Rising electricity and gas prices may effect
old people more than young people. Therefore, old people could have a higher
inflation rate than the national average. This is important if pensions are fixed
because their cost of living may rise as prices rise causing a decrease in living
standards.
As a result of some of the problems above economists measure a core/underlying rate of
inflation to eliminate the effect of sudden swings in the prices of food and oil, for
example.
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
recession. Bad deflation has its origins in a weak 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
Causes of inflation
Inflation can be caused by a number of factors. Economists divide them into two main
groups, demand-pull and cost-push inflation.
Demand – pull inflation
Demand Pull inflation occurs when total demand for goods and services exceeds
total supply. This type of inflation happens when there has been excessive growth in
aggregate demand (particularly when the economy is at or approaching full
employment level).
Demand pull inflation can be illustrated graphically using aggregate demand and
aggregate supply analysis.
LRAS
Demand –Pull Inflation
Price
Level
(GDP
Deflator)
AD3
AD2
Caused by persistent shifts of AD
curve to the right.
P3
P2
P1
AD1
Aggregate demand can increase
by a rise in one of the components
of
demand;
consumption,
____________,
government
spending or net exports
Output (Real GDP)
At low levels of output when there is plenty of spare productive capacity, firms can easily
expand output to meet increases in demand, resulting in a relatively ____________
LRAS curve.
When aggregate demand (AD) increases from AD1 to AD2 the economy is still operating
at relatively low levels of capacity. Output can expand relatively easily with minimal
increases in average costs so firms will only implement small increases in prices from P1
to P2.
As the economy approaches full employment (or full capacity), labour and raw material
shortages mean that it becomes more difficult for firms to expand production to meet
rising demand. As a result, the AS curve becomes more ______________.
When aggregate demand increases from AD2 to AD3 the economy is moving towards the
_______ employment of factors of production. Shortages of factor inputs mean that the
firms' costs of production start to rise and many firms choose to increase price (P2 to P3)
to widen profit margins.
All economists (Keynesian and Classical) agree that once the country’s resources are
fully employed, an increase in aggregate demand must (and only) lead to an upward
movement of prices.
Main causes of increased aggregate demand:







A depreciation of the exchange rate increases the price of imports and reduces
the foreign price of Hong Kong exports. If consumers buy fewer imports, while
foreigners buy more exports, then ______________ increases and demand in the
HK economy will rise. If the economy is already at full employment, it is hard to
increase output and prices are pulled upwards.
A reduction in direct or indirect taxation: If taxes are reduced consumers will
have more disposable income causing ______________ and therefore demand to
rise. A reduction in indirect taxes (taxes on goods and services such as VAT) will
mean that a given amount of income will now buy a greater real volume of goods
and services.
Rising consumer confidence and an increase in the rate of growth of house
prices (increases household ________) - both of which would lead to an increase
in total household demand for goods and services
Faster economic growth in other countries - providing a boost to HK exports
overseas. Remember that export sales provide an extra flow of income and
spending into the HK circular flow. Exports are counted as an ________________
into the circular flow.
Demand-pull inflation is often monetary in origin - because the authorities allow the
money supply to grow faster than the ability of the economy to supply goods and
services. The phrase that is often used is that there is "too much money chasing too few
goods"
Therefore the rapid growth of the money supply as a consequence of increased bank
borrowing if interest rates are _________ and consumer confidence is _________ ,is
often seen as a cause of inflation in its own right. Some economists believe that AD
increases solely, or mostly, because of an increase in the money supply. Such economists
are known as monetarists.
Cost-Push Inflation
In an open economy such as Hong Kong, there are many potential sources of inflationary
pressure. Some come direct from the domestic economy, for example the decisions of
the major utility companies on their prices for the year ahead eg Hong Kong Electric, or
the pricing strategies of the leading food manufacturers based on the strength of demand
and competitive pressure in their markets.
But inflation can also come from external sources, for example a sudden rise in the cost
of crude oil or other imported commodities, foodstuffs and beverages. Fluctuations in the
exchange rate can also have a powerful effect on inflation in the short and medium term.
For now, we focus on the two main causes of cost and price inflation in an economy.
Cost push inflation occurs when firms increase prices to maintain or protect profit
margins after experiencing a rise in their costs of production. This can be shown by
an inward shift of the short run aggregate supply curve which leads to a contraction in
aggregate demand and a fall in ___________, but an increase in the general price level.
Price
Level
(GDP
Price
Deflator)
Cost –push inflation
A rise in factor prices shifts the SRAS curve to
the left from SRAS1 to SRAS2, thereby raising
the price level (P1 to P2) and reducing real
output (Y1 to Y2). For cost-push inflation to
continue aggregate supply must continue to
fall. So a supply side shock will simply lead to
an increase in the price level but this will not
be sustained- therefore- no inflation
Output (Real GDP)
The main causes of cost push inflation are:

Rising imported raw materials costs perhaps caused by inflation in other
countries or by a fall in the value of the local currency in the foreign exchange
markets

Rising labour costs - rising labour costs are caused by wage increases, which are
greater than productivity increases this, is especially important in industries,
which are labour-intensive. If wages account for 25% of a firm's total costs then a
10% increase in the total wage bill will cause the firm's total costs to rise by
_____ %. Firms may decide not to pass on this to their customers (they may be
able to achieve some cost savings in other areas of the business) but in the long
run - wage inflation does tend to move closely in line with general price inflation
in the economy.

Higher indirect taxes imposed by the government - for example a rise in the
specific duty on alcohol and cigarettes, an increase in fuel duties or a rise in the
standard rate of Value Added Tax. These taxes are levied on producers who,
depending on the price elasticity of demand and supply for their products can opt
to pass on the _____________ of the tax onto consumers.
Cost inflation is more likely when unemployment is falling to low levels. In these
circumstances there will be shortages of ________________ labour. This means that
businesses may have to offer higher pay to attract and retain their best workers when they
are looking to expand their output
Rising expectations of inflation can often be self-fulfilling. If people expect prices to
continue rising, they are unlikely to accept pay rises less than their expected inflation rate
because they want to protect the _________________________________ of their
incomes. For example a booming economy might see a rise in inflation from 3% to 5%
due to an excess of AD. Workers will seek to negotiate higher wages and there is then a
danger that this will trigger a ‘wage-price spiral’ as higher wages may cause consumption
levels to rise - further shifting out AD.
THE WAGE PRICE SPIRAL
LRAS
200
AD3
Price
Level 150
(GDP
Price
Deflator
)
SRAS2
SRAS1
100
50
AD2
AD1
0
100 200 300 400 500 600 700 800 900
Real GNY (billions of 1999 US$)
The initial rise in AD causes a temporary rise
in real output, but firms experience rising costs
as factor prices rise. Therefore SRAS shifts in
from SRAS1 to SRAS 2. Higher wages may
cause an increase in consumption levels as
households feel relatively well off- this causes
AD to shift out further to AD3- and the process
continues.