Macroeconomics: Inflation (Problems of Deflation: (Real - wage…
This means there is a fall in the price level (negative inflation rate)
This means there is a falling inflation rate - prices are increasing at a slower rate.
This means a sustained increase in the general price level. If there is inflation, the value of money declines and there is an increase in the cost of living.
A very high and accelerating inflation rate. Usually inflation rate over 500% - where price increases become out of control.
Effects and Costs of Inflation:
Effects on firms
High inflation may create uncertainty and confusion for firms. In periods of high inflation, firms may be less willing to invest because they don't know what their future costs and incomes will be. less investment can reduce the rate of economic growth.
2. Menu costs.
High inflation can create menu costs, which means firms have to adjust price lists. Firms and consumers may also spend more time checking prices.
Effects on the economy:
1. Less investment.
If inflation is high, it can create uncertainty about future costs and therefore firms are likely to reduce investment, leading to lower economic growth.
2. Decline in competitiveness.
Relativity higher inflation in the UK can make UK firms less competitive, leading to lower exports and deterioration in the current account.
3. Higher interest rates.
Governments may be concerned about inflation because of the uncertainty and potential for declining living standards. the BOE may feel the need to increase interest rates.
Effects on consumers:
2. Fall in the value of debt
. High inflation will reduce the value of debt, making it easier for consumers and firms to pay back their debt. With high inflation, borrowers are likely to become better-off, and lenders are likely to become worse-off
3. Fall in real wages.
High inflation could be damaging to workers. if inflation is higher than the growth of nominal wages, real wages will fall. In periods of high inflation, workers will need to bargain for higher nominal wages to maintain their real incomes.
1. Fall in the value of savings.
Consumers who have cash savings will see a fall in the real value of their savings . If inflation is higher than interest rates, savings will decrease in value.
Causes of Deflation
1. Falling aggregate demand.
If there is sharp fall in AD, falling output and a rise in unemployment, then this can lead to lower prices and lower wages.
2. Rising productivity.
If deflation is caused by a fall in costs and rising productivity, then deflation may not be damaging to the economy. This kind of deflation can also cause rising real GDP.
Occurs when there is a rise in costs of firms, leading to SRAS shifting to the left.
Rising wages. Wages are pushed higher by trade unions or a shortage of workers, this will increase the costs of firms
Import Prices. If there is a depreciation in the exchange rate, then import prices will become more expensive, leading to an increase in inflation
Rising oil prices/ raw material prices. This would increase the costs of most firms due to transport goods
Problems of Deflation:
Real - wage unemployment
. If the prices fall, but wages stay the same, it will cause real-wage unemployment. workers often resist nominal wage cut.
Monetary policies become ineffective.
Interest rates cannot fall below 0%. so in theory real interest rates effectively increase.
Higher real debt burden.
If prices and wages are falling, then deflation causes the real value of debt to increase. Debt repayments will become a bigger percentage of income. gives consumers less disposable income.
Government debt as a % of a GDP likely to rise.
Deflation can make it more difficult for the government to reduce debt to GDP ratios.
Falling prices may deter people from buying goods (they wait for them to be cheaper later): this leads to lower AD.
Lower interest rates. Could reduce the cost of borrowing and encourage spending and investments
Rising house prices, which increases consumers' wealth and confidence.
Boom in exports from rising global demand
Income tax cut, which gives consumers more disposable income to spend
A rapid rise in the money supply
Occurs if the economic growth is too fast, If AD rises faster than AS