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CH 7: inflation - Coggle Diagram
CH 7: inflation
effect of inflationdepend on:
- whether inflation is anticipated or not
if anticipated, adjustments can be made
- the extent of inflation (severe vs mild)
mild inflation encourage investment, severe inflation discourage investment
- the extent of inflation relative to inflation in other countries
Generally, when inflation is anticipated, the costs of inflation would be relatively small.
- If people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects. If inflation is anticipated, people would form expectations of inflation.
- They would begin to expect a similar percentage of inflation that had occurred in the past to continue in the future.
- They will also expect their costs - of labour and raw materials, for example - to increase and thus adjust their production plan accordingly.
- Workers will begin to expect the increase in the prices of the goods they buy to be matched by an increase in their wages and thus index their nominal wages to inflation to protect the purchasing power of their money so as to maintain the material aspect of their standard of living.
- With accurate predictions of inflation and thus necessary adjustments, the effects of inflation are not so severe
Unanticipated inflation however results in more pernicious consequences for the economy
- especially if inflation is volatile from year to year, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future. The greater uncertainty with regard to prices, wages and profits will in turn affect the decisions of consumers and firms.
Effects on economic growth via effects on investment
- add to uncertainty in the investment climate and adversely affect investment decisions
- Firms are uncertain about the future prices of their inputs and the prices of their output. The profitability or rate of returns on their investment uncertain, increase in risk, be deterred from investing.
- diversion of efforts towards speculation away from productive activity.
- hoard囤积 both materials and finished products in anticipation of further price increases, restricting the availability of materials and products will tend to intensify inflationary pressures.
- businesses and individual savers may purchase non-productive wealth (e.g. jewels, gold and other precious metals, real estates, etc.) instead of investing capital equipment as hedges against inflation. A fall in investment, fall in AD, lower levels of output and employment in the economy, affect the long term potential growth of the economy as the rate of capital accumulation is reduced and so the growth in productive capacity would be lower.
- (Investment, which is an increase in the total quantity and/or quality of physical capital, will not only have a short-term impact on aggregate demand leading to increasing in actual growth but also has a long-term impact on potential growth (i.e. illustrated by an outward shift of the LRAS curve).)
- However, mild inflation stimulates investment as the rate of return on investments increases, leads the economy to higher levels of output and employment.
- Mild inflation may indicate that the economy is growing at a healthy pace, generate positive expectations about future economic growth. Firms thus expect demand for their products to rise and invest in more machinery and equipment or expand their operations to increase output in order to meet the expected rise in demand and hence increase their profits.
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Effects on resource allocation
- Inflation, distortions in relative prices (by speculative activity or structural rigidities which cause prices to rise at different rates but not reflect long term demand conditions), misallocation of resources.
- Resources may therefore be diverted to goods whose prices are rising faster than others, even though their long term demand may not have changed significantly. This results in allocative inefficiency.
- For example, high and rising inflation may cause people to buy more fixed assets such as gold and property as a hedge against inflation. Such speculative purchases cause prices of property to rise rapidly, increasing the profits of real estate developers and prompting them to build more houses. However, the rise in prices is mainly due to speculative buying and may not reflect the long term needs of the country based on its population demographics. At the same time, prices of essential goods such as rice or oil may be depressed by government price controls, which may not reflect an actual increase in long term demand due to population growth. As a result, too little resources may be allocated for such goods Hence, there would be allocative inefficiency.
Effects on welfare
- Inflation erodes the purchasing power of money, reducing the economic welfare of households.
- Households on fixed income or low wages are more adversely affected as their real income would fall since their nominal income does not increase as much as the general price level.
- worsens income inequality, resulting in an overall decline in economic welfare
- forces low-income households to work harder in order to maintain their standard of living. People may have to work longer hours or take up additional part-time jobs so as to increase their income to keep up with the rising costs of living, higher stress and less time for leisure, reducing the qualitative SOL
menu cost of inflation
- cost involved in constantly revising price lists.
- have to frequently adjust the prices of the goods and services that they sell. As a result, they incur costs every time they reprint and re-issue their product catalogues, publicity material, bar codes and/or menus.
- has an impact on efficiency as it means that time and resources are wasted in having to reprint prices, menus and product catalogues, etc.
shoe-leather cost of inflation
- refers to the time and effort that people take to counteract the effects of inflation.
- The process of making frequent trips to the bank or automated teller machines causes wear and tear on the soles of the shoes. Hence the term "shoe-leather cost" is coined.
- The higher the rate of inflation, the larger the "shoe-leather cost". Shoe leather cost has impact on efficiency as the increase in frequency of transactions results in greater time wastage (ie reduced time spent on productive activities).
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cause of inflation
demand-pull inflation
- excess of AD in a period close to or at full employment.
- economy spends beyond its capacity to produce
- AD increase relative to AS
- however, businesses cannot respond to this excess demand by expanding real output because all available resources are really or already fully-employed
-this excessive demand coupled with a lack of spare capacity to expand output will bid up the prices of fixed real output, causing demand-pull inflation
- As AD increases from ADo to AD1 and then AD2, firms respond by raising prices and partly by raising output
- As the economy approaches full employment (Yf) and specific labour and/or raw material shortages begin to develop, the general price level (GPL) will increase for example from Po to P1, as output cannot be increased sufficiently to meet the higher demand.
- Before full employment(Yf) is reached, at the same time there are still increases to real output. At full employment (Yf), additional spending tends to be purely inflationary as real output cannot increase beyond Yf.
- This means that as aggregate demand increases from AD1 to AD2, GPL will increase from P1 to P2 while the real output will only increase from Y1 to Yf.
1. autonomous increase in
the components of aggregate demand such as C. l, G or net X (changes in real factors)
- The autonomous increase in aggregate demand shifts the aggregate demand curve beyond ADo, leading to the increase in the general price level, hence resulting in demand-pull inflation.
- the magnitude of inflation depends on the magnitude of the increase in AD, as well as the initial state of the economy
Consumption expenditure (C) increases due to consumer optimism
- optimistic about the future, they would save less and spend more thus increasing their expenditure.
- expect their income to rise, decide to spend more on credit, thus increasing consumption expenditure
Investment expenditure (I) increases due to the opening up of new export markets or technological innovations
- To provide for the new export markets, firms would need to invest in plant and equipment or may spend on building up stocks of inputs, semi-finished or finished goods thus increasing their investment expenditure
Government expenditure (G) increases due to increase in national defence expenditures, increase in social needs such as education and healthcare. The increase in healthcare expenditure could be a result of, for example, an ageing population.
Net exports (X-M) increases due to increasing national income of trading partners. With trading partners having higher purchasing power, they could afford to buy more of our exports thus increasing our export income.
2. monetary factors, caused
by expansionary monetary policy of the banking system
cost-push inflation
Cost-push inflation
- occurs when there is a persistent increase in costs of production for reasons not associated with the increase in AD.
- When firms face a rise in costs, they will respond partly by raising prices and passing on the costs to the consumer, and partly by cutting back on production
- resulting in an upward (leftward) shift of the SRAS curve from SRASo fo SRAS1 leading to a rise in the general price level and a fall in real output as shown in figure 2(a).
(a) import price push
- Singapore imports even the most basic of our daily requirements.
- An increase in the cost of imported inputs (raw materials or intermediary products) due to inflation in foreign countries would increase our cost of production leading to a fall in the SRAS curve and hence an increase in the general price level.
(b) Increase in structural rigidities
- Supply-side rigidities (e.g. contractual agreements, lack of flexible wages) prevent the efficient reorganisation of resources to meet changes in the demand for goods and services in the economy.
- Such rigidities prevent prices from adjusting downwards.
- Cost-push inflation may be due to an increase in structural rigidities in the economy, e.g. labour contracts being renewed at higher wage rates, minimum wages being raised by legislation, and increased monopoly power causing firms to raise product prices.
- inflation in Singapore could also be a result of government policies that increase business costs such as an increase in employer CPF contribution rates.
- Such increases in structural rigidities cause costs of production to rise, shown by an upward or leftward shift of the SRAS curve, hence resulting in an increase in the general price level. The government's policy to cut down foreign labour supply which leads to rising wage costs also leads to a fall in the AS, thus causing inflation in Singapore.
(c) Wage push
- Wages are one of the main costs facing firms. Due mainly to the power of trade unions who are able to demand higher wages in excess of productivity growth, the rise in the unit costs of production results in a fall in the short-run aggregate supply curve
- In severe instances, demand for wage increases can lead to a wage-price spiral, adding on to inflationary pressures. A wage-price spiral exists when workers observe that the prices of goods and services have risen demand for even higher wages so as to maintain their purchasing power and if employers accede to their demand will have to charge higher prices for their goods and services in order to compensate for the higher wage bills. That, in turn, leads to further price increases and a spiralling upwards of the general price level.
(d) Currency depreciation
- A weaker currency makes imported raw materials more expensive in terms of domestic currency, thereby leading to higher costs of production. This leads to a fall in the SRAS curve hence a higher general price level.
(e) Supply-side shocks
- Supply-side shocks like natural disasters or epidemics can affect the availability of factors of production within an economy and hence the output in the economy.
- Supply-side shocks may be temporary or short-term in nature, such as floods causing a fall in agricultural output or damage to a major oil well causing a fall in the supply of oil. These supply-side shocks lead to an increase in the cost of production due to the shortage of raw materials, resulting in a fall in the SRAS curve hence a higher general price level.
- Such short term supply shocks do not affect the long term productive capacity of the country and are shown by a leftward shift of the SRAS with no change in LRAS
- However, if there is severe loss or damage of productive resources, the total availability of factors of production may be reduced drastically, and this will lower the productive capacity of a country. This could be due to severe disasters such as major earthquakes or wars which could result in extensive damage to production facilities as well as loss of human lives. These cause the long-run aggregate supply curve to shift leftwards (this also decrease the total output, cause a recession - stagflation)
(f) Profits push
- Due to the monopoly power of firms, prices are generally higher than those in markets with greater levels of competition. Hence, the increasing prices add to costs for various stages of production, causing the short-run aggregate supply curve to fall from SRASo to SRAS1 as shown in Figure2(a). This is especially so if industries such as those which supply raw materials are monopolistic.
Deflation
- While the government tries to achieve a low and stable inflation rate, the opposite of inflation or deflation also results in problems for the economy.
causes of deflation
(a) Deflation may originate with an autonomous decrease in the components of aggregate demand such as C, l,G or net X (changes in real factors)
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Investment expenditure (I) decreases due to decline in confidence.
When firms believe that an economy will perform badly, they would likely cut their investment spending and allocate their resources to economies with better profit opportunities.
Government expenditure (G) decreases due to fiscal austerity财政紧缩 where the government reduce the amount of government borrowing in order to cut the size of the government debt
Net exports(X-M) decreases when a trading partner of a given country practice protectionist policies to restrict its imports, this would in turn reduce the exports of the given country
(b) Deflation due to a decrease in aggregate demand may also originate with monetary factors, caused by a contractionary monetary policy of the banking system (i.e. a decrease in the money supply)
(c) Deflation may also arise on the supply side or cost side of the market when there is a persistent decrease in costs of production for reasons not associated with the decrease in AD.
- Cheaper imports
- Currency appreciation
- Discovery of new resources
- technological advances
effects of deflation
- Effects on economic growth via effects on investment
- Effects on external stability
- Effects on resource allocation
- effects on welfare
- redistribution effects
- Associated with the prolonged economic recession which occurs due to too little spending and investment.
- When there is a sustained decrease in the general price level, consumers pay a lower price compared to previously. Hence, consumers expect the general price level to continue falling and choose not to spend.
- Moreover, they may be more pessimistic about the future and expect wages to fall, so they are more cautious about spending --> depressed demand, firms are forced to lower prices and as inventories piled up, they cut back on production.
- In addition, due to loss of business confidence, investment falls --> fall in AD and a multiple fall in income/output.
- As firms respond to the fall in output by demanding less labour, unemployment increases.
- Deflation also increases the real burden of debt, leading to bankruptcies and possibly increasing the risk of bank failures if the financial system is already fragile. All these negative effects result in a downward spiral of falling incomes, falling demand, falling prices, falling investment and falling employment and output, which makes sustained deflation a serious concern.
- However, not all price declines are necessarily bad.
- In fact, it is nearly always the case that prices of some goods and services will be falling while others are rising at any given time. These price declines reflect the efficient adjustment in relative price levels and could signal the need for a reallocation of resources to relatively more profitable sectors. lt is thus not uncommon for price inflation to turn negative, especially for low-inflation economies. These price declines are generally not a cause for concern.
- Also, net exports may increase during periods of deflation. Deflation makes domestically produced goods seem relatively cheaper while imported goods more expensive assuming no change in value of exchange rates.
measurement of inflation
using price indices:
- a price index is a statistical device used to measure the percentage change in the price of goods or a basket of goods in a particular year compared to a base year
例如：因为某一年的index为105, base year 的 index is calibrated to the value of 100, 这就意味着这一年的价格上涨了5%。
- the inflation rate in a particular year is given by the percentage change in the price index over the previous year (而不是base year！)
例如：2013是base，index为100。2014的index为105,2015为108。2015的inflation rate应该用 (108-105)/105
3 types of price indices
PPI producer price index
- an index of wholesale prices
- measure the price at the point of the first sale
- based on the price of raw materials and intermediate goods purchased by producers
- not a measure of the general price level
- but indicated whether the price is likely to rise or fall in the near future
GDP deflator
- measure change in the economy's average price level
- a ratio of nominal GDP to the real GDP
- more comprehensive than CPI, as it included the prices of all goods and services currently produced in the economy
CPI consumer price index
- average price change in a fixed basket of goods and services typically purchased by residents' households over time
- weighted average of retail prices
- all goods and services are given different weights according to the percentage of income that households spend on them
dergee of inlfation
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moderate inflation
- less than 10% annually
- mild inflation of 2-3% is beneficial such as reinforcing business/investors' optimism and confidence
disinflation: positive inflation, but percentage got lower and lower (increase at a decreasing rate)
deflation: negative inflation, general price level decrease