Low and Stable rate of inflationIB Economics
InflationInflation is what?A persistent rise in average prices in the economy (learn this!!)How is it measured?Normally using the CPI – Consumer Price IndexWhat is the inflation target?Depends on the countryThe UK is 2% CPIWatch inflation videoShow how prices have changed over the years
Inflation – a persistent increase in the average price level in the economy usually measured with the CPI (Consumer Price Index)
Why worry about inflation?There are a significant number of negative consequences associated with high levels of inflationLoss of purchasing power
If the rate of inflation is 2% the average price of all goods and services in the economy has risen by 2%
If your salary/wages stays the same then it means you can buy less goods and services
Your purchasing power (the amount you can buy) has been reduced
In this case we say that you have had a fall in real income (income adjusted for inflation)
Why worry about inflation?Loss of purchasing power
If your income was linked to the inflation rate you would automatically get a 2% cost of living increase which means your real income has remained the same
If you worked for a company that had a strong union this may be the case but lots of people do not have inflation linked incomesSelf employed, weak trade unions,
fixed incomes (old people on pensions/unemployed on benefits)
Expected rates of inflation are important
If your company expects 1.5% inflation and gives you an increase of 1.5% but then the inflation rate turns out to be 2% your purchasing power will have reduced
Why worry about inflation?Effect on savingIf you save $1000 in the bank at 4% annual interest you will end up with $1,040If the inflation rate is 6% then the real rate of interest (the interest rate adjusted for inflation) will be negative (4% - 6% = -2%)Your savings will not buy as much as they did the year beforeYou would have been better to spend it than save itYou will have lost purchasing powerInflation therefore discourages savingPeople will buy assets such as houses or art which will be worth moreAs the bank uses savings to lend to others – less saving will mean less funds for investmentThis may have negative implications for growth
Why worry about inflation?Effect on Interest RatesCommercial banks make money from charging interest to people who borrow moneyIf there is a high rate of inflation banks will raise their interest rates to keep the real rate that they earn positiveEffect on international competitivenessIf a country has a higher rate of inflation than its trading partners its exports will be less competitiveImports from lower-inflation countries will be more attractiveThis may worsen the balance of paymentsThis could lead to unemployment in export industries and industries that compete with imports
DeflationThere is good deflation and bad deflationGood deflationThis comes about from the LRAS shiftingOutput will increase and price levels with fallThis assumes that AD remains (ceteris paribus)This will also give a lower level of unemployment (derived demand for labour from the increased demand for goods and services
Deflation – a persistent fall in the average price level in the economy usually measured with the CPI (Consumer Price Index)
DeflationBad deflationThis comes about from AD shiftingA downwards shift of AD will result in lower price levels but also lower output (less growth)This could lead to an increase in unemploymentDemand for goods and services will decreaseLabour is a derived demandIf people think prices will go down they will put off consumptionWhen they see prices fall this will confirm their thoughtsThey will further put off consumption and AD will keep falling
Deflation Japan has a problem with deflation Banks collapsed due to bad debts and
bad investments in their own stock market
People built up precautionary savings in case they lost their jobs
This depressed consumption and AD Interest rates were cut to 0.25% but it
didn’t work The damage had been done Consumer and business confidence
crumbled with people and firms reluctant to spend
Don’t confuse deflation with a falling rate of inflation (this is called disinflation)
Deflation/Disinflation From 1999 to 2000 the inflation rate
rose from 1.2% to 1.6% From 2000 to 2001 the inflation rate
fell from 1.6% to 1.3% the average level of prices rose
but at a lower rate than the previous year – disinflation
In the next two years the inflation rate continued to fall (prices were still rising but by a smaller and smaller amount)
In 2004 the country started to experience deflation (the average level of prices fell by 0.5%)
From 2004 to 2005 the country was still in a period of deflation where average prices fell by 0.3%
Do you understand? Which period of time did Japan experience
a) Inflation
b) Disinflation
c) deflation
Costs of Deflation Although consumers may be pleased with falling
prices there are many problems with deflation Deflation is also a bit of an unknown so it is more
difficult to deal with than inflation Some economists argue that the costs of deflation
are higher than inflation Unemployment If AD is low businesses may lay off workers If prices fall consumers will put off purchasing Firms will have to drop prices to encourage
consumption Consumers will again put of purchasing believing
that prices will fall further (deferred consumption) Consumer confidence drops further depressing AD This is known as a deflationary spiral Investment will also be put off
Costs of Deflation Costs to debtors Anyone who has taken
a loan (including house buyers who have taken a mortgage) suffers from deflation because the value of their debt rises
If profits are low businesses will find it difficult to pay back loans
There may be many bankruptcies
This will make business confidence even worse Play Japan
Inflation video
Measuring Inflation - The Consumer Price Index (CPI)
The CPI is a weighted price index used to measure the change in the prices of a typical basket of goods and services
The contents of the basket are changed each year
In the UK they use information from the Family expenditure Survey
Changes in weighting reflects changes in spending behaviour (the more that is spent the higher the weighting)
In 2008 fruit smoothies, muffins and USBs were included in the basket
Microwaves, 35mm camera film and CD singles were removed
Family Expenditure Survey: a representative monthly survey of UK household expenditure used to derive changes in the CPI
Limitations of the consumer price index as a measure of inflation Different population groups experience different rates of inflation
The CPI is an average household and not representative of individual households
The weighting for tobacco or motoring expenses will be irrelevant for non smokers and those without a car
The CPI does not include house prices Mortgage prices will be a high proportion of spend of younger house
buyers Many older home owners will have paid off their mortgages
The CPI may overestimate inflation Price rises may hide improvements in the quality of goods and services Cars and electrical goods may have gone up in price but this is due to
new innovations
Causes of inflation Inflation comes from several
sources It can come directly from the
domestic economy Price strategies of leading food
retailers based on the strength of demand or competitive pressures
A rise in VAT cause firm’s production costs to go up and these being passed onto the consumer
It can come from external sources Increase in price of crude oil or
other imported commodities, foodstuffs and beverages
Changes in exchange ratesA falling pound against the Euro
might cause higher import prices (remember WIDEC?)
Causes of inflation There are 3 main types of inflation
that are caused by different thingsa) Demand pull inflationb) Cost push inflationc) Excess monetary growth
As the name suggests demand pull inflation is caused by an increase demand (AD) Most likely to occur when there
is little spare capacity in the economy
Increase in AD will lead to an increase in prices
When does AD increase? When one or more of the
components increases Draw a diagram illustrating demand
pull
Causes of inflation Cost push inflation occurs as a
result of an increase in the costs of production
Any increase in a firm’s costs pushes the supply curve up
If the cost of an input such as oil that affects the costs of all business in the economy increases the SRAS will shift upwards
Things that cause production costs to go up and force firms to raise their prices to maintain profit margins A rise in costs of imported raw
materials (e.g. by a fall in the value of the country’s currency)
Rising labour costs Higher indirect taxes Wage price spirals
Causes of inflation Cost push and demand pull
together Let’s say house prices rise and
the wealth effect comes into play The economy has little spare
capacity (it is working close to full employment)
Consumption increases aggregate demand increases
capacity causing demand pull inflation (1)
workers will demand higher wages to help them keep their current standard of living
This demand for higher wages will cause cost push inflation (2)
Higher wages may also give households the illusion that they have more money
This will further increase consumption and increase AD (3)
Causes of inflation Excess monetary growth Monetarists (a branch of new classical
economists) believe that inflation is caused by excessive increases in money supply
If there is more money in the economy there will be higher spending
AD will increase Because this is a new classical theory
we draw the LRAS vertical Increasing money supply (quantitative
easing) tends to be a policy of last resort
In the UK the Bank of England has recently (2012) decided on a policy of QE because the low interest rates were not encouraging consumption
They believe it is safe to do this because there is spare capacity in the economy but are watching the outcome carefully
Milton Friedman (1912-2006) was a Monetarist who passionately believed that government intervention always causes more harm than good
Reducing inflation The appropriate policy depends on the cause
of inflation If the cause is the price of oil then this is an
external factor which is out of government’s control
If it is demand pull inflation government can try to dampen demand using deflationary/contractionary fiscal or monetary policy
Evaluation There are often problems with contractionary
policies Increasing taxes, reducing government
spending or putting up interest rates are not popular measures
There are lags with both fiscal and monetary policy of 1 to 2 years
Government spending budgets are developed over a long period of time and may need lengthy legislative procedures to make any changes
Reducing inflation / Evaluation Monetary policy will harm some people in the
economy more than others Anyone that has a loan or mortgage and
businesses that want to invest Any government that is looking to be re-
elected will be reluctant to use these measures
This is one of the reasons that many developed countries have monetary policy managed by their central bank which is an independent body
The UK MPC need to make sure that inflation is kept within +/- 1% of 2.5% otherwise they have to write a letter to the government explaining why
The Fed does not have an official target It is important that people have faith in the
central bank to keep inflation rates stable or they will demand higher wages
Reducing inflation / Evaluation Nowadays monetary policy is
considered to be the most effective way of managing AD in the economy
Interest rates are seen as the best weapon
Fiscal policy is not seen as an effective tool for inflation
Governments have commitments to the public so it is very difficult to cut spending
Plus any cut in G would take a long time to have an effect on price levels.
Supply side policies are used to fix cost push inflation (as long as it is a domestic issue)
It is really difficult to say which bit of inflation is cost push and which bit is demand pull so policy makers tend to use a mix of solutions
Reducing inflation / Evaluation The biggest issue with reducing AD
is the loss of output and hence unemployment
Potentially there is a trade off between inflation and unemployment
If unemployment is lowered AD will increase causing inflation
If inflation is lowered AD will decrease causing unemployment
Responsibility for managing AD might be best left to automatic stabilizers of fiscal policy and careful changes in monetary policy carried out by and independent central bank
HL onlyCalculating Inflation
Using index numbers This is straight forward if you
can calculate percentage changes
This table shows the made up index of house prices
2005 is the base year In 2006 there is an increase of
8.4% so the index goes up to 108.4
In 2007 there is an increase of 20% since 2005 so the index is 120.0
We need to take more care when working out the percentage change from 2006 to 2007
It is not 11.6% It is (120-108.4)/108.4 x 100 =
10.7% (Difference between the two
years divided by the original year)
Year Index
2005 100.0
2006 108.4
2007 120.0
Using index numbers When we bring several indices together in a basket we have to
give each one a weighting The weighting will depend on the proportion of income that is
spent on that good If we take this example on average 40% of income is spent on
housing so it gets a weighting of 0.4 To work out the weighted index you just multiply the index by the
weight Category Index
for year X
Weight Index for year X times weight
Index for year X +1
Weight Index for year (X+1) times weight
Housing 120 0.4 48 130 0.4 52
Foodstuffs 105 0.2 11 105 0.2 11
Travel 120 0.2 24 125 0.2 25
Clothing 120 0.1 12 110 0.1 11
Entertainment 125 0.1 12.5 130 0.1 13
Totals 107.5 1 112
Using index numbers To find out the rate of inflation you need to do the following sum New index – old index divided by old index In this case it would be Index for (X +1) minus Index for X
divided by Index for X Multiply by 100 to get the % inflation rate (112 – 107.5) / 107.5 = 4.2%
Category Index for year X
Weight Index for year X times weight
Index for year X +1
Weight Index for year (X+1) times weight
Housing 120 0.4 48 130 0.4 52
Foodstuffs 105 0.2 11 105 0.2 11
Travel 120 0.2 24 125 0.2 25
Clothing 120 0.1 12 110 0.1 11
Entertainment 125 0.1 12.5 130 0.1 13
Totals 107.5 1 112
Time for you to do some work!!For homework do some research on inflation in your chosen country SL – P241 1a & bHL – P242/3 Data Response
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