Chapter 31 - Inflation and
deflation
Inflation is the sustained rise in the general price level of goods and services in
an economy over time, measured by a consumer price index.
Hyperinflation refers to very high rates on inflation that are out of control,
causing average prices in the economy to rise very rapidly.
Deflation is the sustained fall in the general price level in an economy over time,
i.e. the inflation rate is negative.
One type of deflation, known as benign or non-threatening deflation, can be
caused by higher levels of supply of goods and services, thus increasing the
productive capacity of the economy. This drives down the general price level
of goods and services whilst increasing national income. It can be caused by
technological advancements, government subsidies for major industries and
investments in education and infrastructure.
Malign deflation is deflation that is harmful to the economy. It is caused by
lower levels of demand in the economy, thus driving down the general price
level of goods and services. During an economic recession, consumption of
goods and services falls due to lower GDP per capita and higher levels of
unemployment. This type and cause of deflation is a concern as it
associated with a decline in national income and standards of living.
Measuring inflation and deflation:
The Consumer Price Index (CPI) is a weighted index of consumer prices in
the economy over time. It is used to measure the cost of living for an
average household.
The base year refers to the starting year when calculating a price index.
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Causes of inflation and deflation:
Cost-push inflation is a cause of inflation, triggered by higher costs of
production, thus forcing up prices. Higher material costs, increased wages,
and soaring rents causes economic activity to fall, thereby reducing real
national income.
Demand-pull inflation is caused by higher level of aggregate demand, thus
driving up the general price level of goods and services. During an economic
boom, household consumption increases due to higher GDP per capita and
higher levels of employment. This causes an increase in real national
income but forces up the general price level in the economy.
Monetary causes of inflation are related to increases in the money supply
and easier access to credit such as loans and credit cards.
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Imported inflation occurs due to high import prices, forcing up costs of
production and therefore causing domestic inflation.
Consequences of inflation:
Menu costs - Inflation impacts the prices charged by firms thus catalogues,
price lists, and menus will have to be updated regularly. This is very
expensive for firms due to the labour and capital costs involved.
Consumers - The purchasing power of consumers decreases when there is
inflation because there is a fall in real income as money is worth less than
before.
Shoe leather costs - Consumers have to spend more time and effort
searching for better priced goods and services thus there is an opportunity
cost.
Savers - Will lose out from inflation, assuming there is no change in interest
rates for savings. This is because the money they have saved is worth less
than before.
Lenders - Will lose out because the money they lent out borrowers will be of
less worth than before due to inflation.
Borrowers - Tend to gain from inflation as the money they need to repay is
worth less than when they borrowed it.
Fixed income earners - See a fall in their real income since money is worth
less but they’re earning the same amount as before. Pay rises are also
worth less due to inflation.
Low income earners - Tend to have a high PED for goods and services thus
are harmed more by inflation.
Exporters - The international competitiveness of a country will tend to fall
when there is domestic inflation. Higher prices make exporters less
competitive causing a drop in profits.
Importers - Imports become more expensive for all the economic agents due
to a decline in the purchasing power of their money. Essential imports such
as petroleum and food may cause imported inflation which can cause
problems for countries without many natural resources.
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Employers - Workers are likely to demand a pay rise during times of inflation
in order to maintain their level of real income. Thus, labour costs of
production would rise and, ceteris paribus, profit margins would fall.
Business confidence levels - Inflation causes uncertainty in the economy.
The combination of uncertainty and lower than expected real rates of return
on investment tends to lower the amount of planned investment in the
economy.
Consequences of deflation:
Unemployment - Deflation causes a fall in demand for labour as it occurs
due to a fall in demand for goods and services.
Bankruptcies - Since consumers spend less during periods of deflation, firms
earn less revenue and profit, thus making it hard to repay loans and other
costs.
Wealth effect - The wealth of shareholders falls because dividends and
capital returns decrease due to a fall in profit.
Debt effect - The real costs of debts increases when there is deflation
because real interest rates rise when the price level falls.
Government debt - Due to more bankruptcies, unemployment and lower
levels of economic activity, tax revenues fall while government spending
increases (to try to pull the economy out of deflation by increasing aggregate
demand). This creates a budget deficit for the government meaning that it
needs to borrow money even though the real cost of borrowing rises with
deflation.
Consumer confidence - Falls as consumers fear the situation of the
economy will worsen. They may postpone their spending especially on
durable goods as they expect prices to fall even further in the future. This
worsens deflation.
Policies to control inflation and deflation:
Fiscal Policy - If there is demand-pull inflation in an economy (the general
level of demand is too high), the government may use contractionary fiscal
policy and raise taxes and/or reduce government expenditure to reduce the
level of economic activity.
During times of deflation, the opposite must be done and expansionary fiscal
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policy must be used to increase demand in the economy again. This can be
done by tax cuts and increasing government spending
Monetary Policy - If the government chooses to impose high interest rates
(which makes the cost of borrowing increase) to reduce consumer and
investment expenditure, this may reduce the level of economic activity in the
economy and reduce inflation.
During periods of deflation, interest rates must be decreased (which
decreases the cost of borrowing) to provide consumers with an incentive to
borrow money. Thus, raising consumer and investment expenditure and
lowering the level of deflation.
Supply-side policies - Monetary and fiscal policies are used to control
inflation and deflation in the short term while supply-side policies increase
the economy’s productive capacity which helps it to grow without suffering
from the costs of inflation.
Exam-style questions - Page Number 217
a) Inflation rate is the rate of inflation in an economy over a particular period of
time and inflation is the sustained rise in the general price level of goods and
services in an economy.
b) The rate of inflation was highest in the third year because inflation is a
compounded value. This means that the rate of inflation in the third year if
compared with the first year, would actually be: 1.025*1.017*1.023 = 1.066400
1.066400*100 = 6.64%
Activity - Page Number 220
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1. 129.15 - 123.0 = 6.15
6.15 ÷ 123 = 0.05
0.05 x 100 = 5%
2. 100x - 3x = 130
97x = 130
x = 1.3402
100x = 134.02
3. 135 - 125 = 15
15 ÷ 125 = 0.12
0.12 x 100 = 12%
1200 + (12*1200/100) = 1200 + 144 = $1344
Exam-style questions - Page 220
a) The consumer price index is a price weighted index of consumer prices in an
economy over time. It i used to measure the cost of living for an average
household.
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b) The weighted index of clothing would be: 110 x 0.1 = 11
The weighted index of food would be = 120 x 0.2 = 24
The weighted index of housing would be = 130 x 0.3 = 39
Since the weighted index of the product housing is more than clothing or food,
the typical household in Jukeland spends more money on housing than on food
or clothing.
Exam-style questions - Page 221
1. A
2. A
Exam-style questions - Page 222
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a) It was lowest in the middle of 2009 and highest in the middle of 2008.
b) Cost-push inflation is caused by an increase in the costs of factors of
production thus causing producers to increase prices in order to maintain their
profit margins. Demand-pull inflation occurs in the economy due to higher level
of demand. Since price and demand are positively correlated, the general price
level in the economy also increase. Demand-pull inflation is generally
associated with higher GDP per capita and lower unemployment while cost-push
inflation is associated with a reduction in real national income.
c) Inflation is a sustained rise in the general price level of goods and services in
an economy. A global financial crisis would cause a fall in the rate of inflation
because inflation occurs when the price level in the economy is high. However,
during a financial crisis the money supply in the economy would decrease thus
costs of production and demand would decrease, making it unlikely for either
cost-push inflation or demand-pull inflation to occur. Thus, the rate of inflation
would decrease.
Exam-style questions Page 225
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a) Deflation is the sustained fall in the general price level of goods and services
in the economy.
b) Deflation occurs in the economy when the rate of inflation falls below 0 or is
negative. According to the graph the inflation rate was below 0 in most of 2007,
almost continually from 2009 to 2013 and in parts of 2016 too. This is evidence
that the economy of Japan has suffered from periods of deflation from 2007 to
2017.
c) There are many effects of deflation that Japan could suffer from:
One effect or consequence is unemployment. Since consumer confidence
decreases during periods of deflation, consumer spending decreases and thus
the revenue of firms falls. This causes both pay cuts and workers being laid off.
Another effect of deflation is bankruptcies. Consumer spending decreases
during periods of deflation thus there is less demand for goods and services.
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Lesser demand decreases prices and thus firms make less profit and are less
able to pay off their debts and suppliers. This may lead the business to
bankruptcy.
Government debt also increases during deflation because tax revenues
decrease as a result of more bankruptcies and less consumer spending and
investment. At the same time, the government spends more to decrease inflation
by increasing aggregate demand. This results in a budget deficit and causes the
government to borrow more money.
a) Inflation is the sustained rise the general price level of goods and services in
the economy. The inflation rate in Iran in the year 2012 was around 26 and 27
per cent. However in 2013, it had risen up 36%. This indicates that the inflation
rate was higher in 2013 than 2012. When the rate of inflation in the economy is
higher, the price level of goods and services is also higher. Thus, if the inflation
rate in Iran was higher in 2013 than 2012, the general price level would be too.
b) Two reasons why the Iranian government might aim to control the level of
inflation in its economy are:
Inflation causes uncertainty in the economy which leads to less consumer
spending and less planned investment. This would decrease the tax revenues of
the government, causing a slowdown in government spending on public goods
which would have negative consequences for the economy. The GDP and GDP
per capita of the country would also fall and thus decrease economic growth and
development.
Domestic inflation also causes a reduction in international competitiveness.
Imported goods would become more expensive in a country and exports would
fall in terms of real value. If the country needs to import essential goods such as
petroleum or food, this may result in imported inflation.
c) High inflation rates would affect low-income earners more than high-income
earners and wealthy people. This is because low-income earners often have a
high PED so a double-digit inflation rates nearing 30% would affect their ability to
purchase and goods and services. Some low-income earners would not be able
to afford even essential goods because of the high levels of unemployment in
the economy during inflation. High-income earners, on the other hand, have
large amounts of accumulated wealth and thus are able to purchase goods and
services during periods of inflation.
Chapter Review Questions:
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1. Inflation is a sustained rise in the general price level of goods and services in
the economy.
2. The Consumer Price Index is a weighted index of consumer prices in the
economy over time. It is used to measure the cost of living for an average
household.
3. Weights are used in the calculation of CPI because the products measured
are of different degrees of important to the typical household, so statistical
weights are applied to reflect this.
4. The base year is the starting year when calculating a price index.
5. Inflation is the sustained rise in the price level of goods and services in the
economy. The two main ways this can happen is either by increased costs of
production resulting in higher prices of products, or increased demand for
products resulting in an increase in price since demand and price are
positively correlated.
6. The main consequences of inflation are; decreased purchasing power of
consumers, less consumer confidence, decreased cost of borrowing,
increased cost of imports and fall in real national income.
7. Deflation is the sustained fall in the general price level of goods and services
in the economy. i.e. The interest rate is negative.
8. The two main causes of deflation are lower costs of production due to
currency appreciation and and improved technology, and falling demand due
to decline in confidence and fall in money supply.
9. The main consequences of deflation are; higher levels of unemployment,
more common bankruptcies and business failures, reduction in wealth of
shareholders and increase in the real costs of debts or borrowing.
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10. Fiscal policy involves the use of tax rates and government spending,
monetary policy the use of interest rates and to a lesser extent, supply-side
policies the use of education and training to control the level of inflation. For
example, tax cuts can decrease the level of deflation by encouraging
consumer spending and higher rates of interest can decrease the level of
inflation by raising the cost of borrowing and discouraging economic activity.
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