Inflation

Define:

*Inflation is the sustained increase in the general price level*

*Deflation is the sustained decrease in the general price level*

*Disinflation is the fall in the rate of inflation; involves a positive rate of inflation in contrast with delfation*

*Stagflation is when there is persistent high inflation combined with high unemployment and stagnant demand in a country's economy*

Consumer price index

It is a measure of the costs of living in the typical household and how this changes over time.

Limitations

  • Different income groups consume different combinations of g's and s's. Thus, they face different inflation rates than those calculated in the basket
  • The quality of products may improve over time. The CPI cannot account for this
  • Consumers are increasingly using discounts or sales. The CPI cannot account for this as prices are lower than those in the calculations
  • Changes in consumption patterns due to consumer substitutions when relative prices change -- Results in changing weights as g's and s's prices fluctuate causing the consumer to change buying habits
  • Cross country comparison is not possible due to differing CPI's -- types of g's and s's bought.

It is calculated by taking price changes for each item in predetermined baskets and averaging them.

The more of the product consumers consume the more 'weight' it will have in the basket.
e.g. Consumers buy one iPhone a year v fruit weekly

Other ways to measure

The basket is redone every 10 yrs but the limitations are still not eliminated

Producer Price Index

The core (underlying) rate of inflation

Some product groups have highly volatile prices - oil and food - thus, causing misleading in the inflation trend when included in the CPI. The 'core' group excludes these volatile goods / services

It measures change in the avg. prices of FOP's thus, PL changes from producers perspective not consumers. As the PPI measure PL changes at early stages in production, it is useful in predicting changes in future inflation.

Consequences

Redistribution effects

Types and causes

Demand pull

Cost push

Caused by an increase in the costs of production or supply shocks = DECREASE in SRAS

Caused by the determinants of AD = C + I + G + (X-M) = INCREASE in AD

Uncertainty

Menu costs

Less saving

Damage to export competitiveness

  • Losses to
    • Holders of cash, savers, lenders and people receiving fixed income / wages as the REAL VALUE falls
  • Gains to
    • The borrowers and payers of the fixed income / wages. As the REAL VALUE of their payment falls therefore, essentially, they gain money.

Inability to predict future prices and PL changes cause uncertainty among firms who cannot accurately predict future revenues and costs of production = negative effect on investments = economic growth

High rates cause restaurants or firms to have to reprint menus, catalogues etc. which only increase their costs of production

As they lose real value thus, they lose the incentive to save ( if interest is not high enough)

High inflation = exports are more expensive for foreigners = ⬇ whereas, imports ⬆ due to cheaper costs. This causes net exports(X-M) to ⬇ and also AD.

Some may be avoided through:

  • Payment of interest to savers and lenders that is at least as high as the rate of inflation.
  • Increases in income or wages that is at least as high as the rate of inflation.

Gov policies

Gov policies

Causes PL ⬆ and RGDP ⬆. The increase in PL is demand-pull inflation.

Causes PL ⬆ and RGDP ⬇ = serious for the economy

Contractionary fiscal policy: G⬇, T⬆

  • Effective in addressing high and rising inflation
  • G is a component of AD. Decrease impacts the economy
  • Time delays, politically unpopular, political interference

Contractionary demand side policies: used but make the recession deeper and more extensive

Idea of 'Too much demand chasing too little supply'

The increase in the PL due to the fall in SRAS = cost push

Contractionary monetary policy: Interest rate ⬆ = C⬇ and I ⬇

  • Quick
  • No political interference
  • Higher interest rates may affect AD after time lag

Supply-side policies: Appropriate but face time lags.

  • If it is due to rising wages, the policy should aim at stopping the wage increase.
  • If it is due to rising profit due to excessive monopoly power, policies should aim to decrease monopoly power of firms
  • It is due to a depreciating currency (import prices rises for domestic buyers), policies should aim to reduce dependence on imports
  • If it is due to increasing prices of oil or food, policies should aim to reduce oil dependence