Inflation
- Inflation is the sustained increase in the average price level.
- Low and stable inflation (around 2%) is one of the macroeconomic goals.
- Inflation is kept in check primarily through monetary and fiscal policies.
- Inflation rate is the percentage change in prices from year to year.
Disinflation
- Disinflation is when the average price level is continuing to rise but at a slower rate.
- The rate of inflation is still positive but lower than previously recorded.
- Make sure not to confuse disinflation with deflation, as during disinflation there is still an increase in the average price level.
- In an AD-AS diagram, a decrease in the price level in the short term can be considered to show disinflation.
Causes of Inflation
Cost-Push
- Inflation as a result of an increase in the costs of production in the economy, such as an increase in the price of raw materials, imports or labor.
- Price level is pushed up.
- In an AD-AS diagram, SRAS decreases and shifts to the left.
Demand-Pull
- Inflation as a result of an increase in AD (C + I + G + Xn).
- The price level is pulled up.
- In an AD-AS diagram, AD increases and shifts to the right.
Money Supply
- An increase in the money supply can also lead to inflation.
- If there is too much money in circulation, spending is increased, resulting in an increase in AD and therefore inflation.
Inflationary Sprial
- Demand-pull inflation and cost-push inflation combined can cause an inflationary spiral.
- As consumers drive prices higher, businesses also pay higher prices.
- Additionally, workers demand higher wages due to the increase in the cost of living.
- These events fuel even more inflation.
- The cycle builds on itself, leading to more and more inflation.
- An inflationary spiral can lead to hyperinflation, causing super high prices.
- This makes it very difficult to export goods, leading to lay-offs.
- On an AD-AS diagram, an inflationary spiral can be seen as a continuous upwards shift in the SRAS and AD curves.
- SRAS decreases, and AD increases as a result, causing SRAS to decrease and so forth.
Costs of High Inflation Rate
Uncertainty
- Lack of confidence leads to businesses and consumers being careful, reducing their consumption and investment.
- It could possibly lead to over-consumption if consumers expect prices to be higher in the future.
- This further drives inflation.
Redistribution Effects
- Low income households are affected more than higher income households, leading to inequity.
Saving Effects
- If the inflation rate is greater than an interest rate, you are better off not saving money.
Decrease in Economic Growth
- A decrease in purchasing power and uncertainty leads suppliers and consumers to reduce economic activity.
Damage to Exports
- Inflation makes domestic goods more expensive for trading partners
Solutions to Inflation
- Inflation is a short-term problem that needs a short-term solution
- Demand side policies are more short term focused, so they would apply
- Supply side policies are generally long term and too slow to take affect
Which Demand Side Policies?
- Contractionary policies such as increasing taxes and reducing government spending are highly unpopular and might bring GDP (further) down.
- This is the reason central banks are indepedent from the government.
- The central bank does not need to be popular as they aren't elected.
- Central banks often have 1 task: keep inflation low or around 2%
- Monetary policies are seen as the best way to control inflation
Economic Goals of Low Inflation and Low Unemployment
- In the peak of a business cycle, there is low unemployment yet high inflation.
- In the trough of a business cycle, there is high unemployment and low inflation.
- It is difficult to make the two exist at the same time, as unemployment directly affects aggregate demand which affects inflation.
- When there is low unemployment, people have more spending power, leading to an increase in consumption and thus AD, leading to cost-push inflation.
- When there is low inflation, it is often due to lower AD.
Deflation
- Deflation is a sustained decrease in the average price level or a negative inflation rate.
- Deflation is avoided because people hoard money and assets due to an increase in value.
- This decreases consumer spending (GDP).
- The 2% inflation rate lets there be a buffer between inflation and deflation.
Good Deflation
- In an neoclassical AD-AS graph, if the LRAS curve shifts to the right, then there is an increase in real GDP, yet a decrease in the price level, assuming AD stays the same.
- While a mostly theoretical scenario, this would be beneficial to the economy, and is called good deflation.
- This is because it leads to economic growth, and a reduction in the aggregate price level means those with less income now have more purchasing power.
Bad Deflation
- Bad deflation occurs when aggregate demand falls.
- This means there is reduced GDP due to a recessionary gap, and thus it is called bad deflation.
Costs of Deflation
Uncertainty
- Lack of confidence leads to businesses and consumers being careful
Deferred Consumption
- Consumers defer to spend money as their money is gaining value
- This can lead to hoarding which reduces consumption, causing more deflation.
Cyclical Unemployment
- Deflation typically indicates falling economic output, meaning firms may have to lay-off workers
Increase in Real Value of Debt
- Size of real debt grows as money gains in purchasing power.
Re-distributive Effects
- Winners: fixed income earners and lenders (banks).
- The money earned from interest payments or from fixed incomes has far more purchasing power.
- Losers: borrowers and providers of fixed incomes (e.g. government).
- Borrowers have to pay higher interest and fixed income providers have to pay more for income as deflation increases the purchasing power of these fixed amounts.
- This causes inequity as certain groups benefit from deflation whereas others lose.
Policy Ineffectiveness
- Even with the use of expansionary monetary and fiscal policies, it will be difficult to convince firms and consumers to borrow money.
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