chapter 7

causes of inflation

effects of inflation

control of inflation

measurement of inflation

demand pull inflation: AUTONOMOUS increase in components of AD

cost-push inflation: persistent increase in costs of production for reasons not associated with increase in AD

consumption increases due to consumers optimism

investment increases due to new export markets or technological advancement

government expenditure increases due to increase in national defence/ increase in social needs

net export increase due to increased national income of trading partners

rise in costs of production causes firm to raise their prices and passing on the cost to their consumers and also by cutting back on production --> upward shift of SRAS --> increase in GPL

explanation: excessive increase in aggregate demand, firms will increase prices partly increasing output. as the economy approaches Yf, firms face immense competition for resources due to shortages in raw materials --> output cannot be increased to meet the higher demand, causing general price level to increase.

due to

import price push: increase in cost of imported inputs will increase cost of productions hence fall in SRAS

increase in structural rigidities: supply side rigidities (in the form of contracts, some agreements) prevent the efficient reorganisation of resources to meet the changes in demand for good and services

wage push: presence of trade unions who are able to demand higher wages in excess of productivity growth --> higher unit cost of production, leading to fall in SRAS (not applicable in singapore BUT a wage spiral can also occur: workers observe that price of good increase, demand for higher pay to maintain their purchasing power and if the employers accede to their demand, will have to set higher prices to compensate for higher wage bills --> further price increases and spiralling upwards of the general price level

currency depreciation (applicable in sg): weaker currency makes imported raw material expensive, thereby leading to higher costs of production

supply-side shocks: natural disasters/ epidemics can affect the availability of factors of production within an economy and hence output of economy

profits-push (applicable to monopoly supplier): large firms can set high prices INDEPENDENT of consumer's demand to increase profits. this leads to increases prices at different stages of production, thereby leading to higher costs of production and higher general price level

inflation+recession = STAGFLATION

price index

involves a base year, index is calibrated to the value of 100. i.e. if price index is 105 then GPL has increased by 5% as compared to BASE year

inflation rate

percentage change in the price index over the previous year

consumer price index (CPI)

measures average price change in a fixed basket of goods and services typically purchased by a resident households over a year.

weighted average of retail prices

producer price index (PPI)

prices at the point of first sale , based on price of raw materials and intermediate goods purchased by a producers

GDP deflator

changes in the economy's average price level

depends on

internal stability

whether inflation is anticipated

extent of inflation relative to other country

severe or mild inflation

external stability

EFFECTS OF DEFLATION

on actual and potential economic growth

on efficiency/ resource allocation

on welfare (equity)

balance of payments

external value of currency

SEVERE inflation

MILD inflation

stimulates investment as rate of returns on investment increases thereby leads the economy to higher level of output and employment

creates a lot of uncertainty and is seen as an increase risk and may be deterred from investing. fall in investment causes AD to fall and leads to lower level of output and employment in the economy. (short run)

rate of capital accumulation is reduced so growth in productive capacity is lower --> affect long term potential growth of economy

inflation erodes the purchasing power of money and reduce economic welfare of households and tend to worsen income inequality

menu costs of inflation: need to constantly reprint menu cost due to frequent adjustment of prices

shoes-leather cost: time and efforts that taken to counteract the effects of inflation

effects of low and stable inflation rate

consumers

producers

economy

certainty of future prices stimulate investment --> economic growth --> fall in unemployment --> improvement in balance of payment

prevents decline in standard of living, encourages savings

increase profitability: firms can make long terms plans as prices are certain. firms will also invest of improve productivity

greater efficiency: fall in menu costs/ sheos-leather cost

AD falls below the full employment level due to lower consumption,etc ( the factors of AD), this leads to decrease in general price level. hence, firms will decreases production, thereby leading to higher level of unemployment and this will lead to downward spiral of falling income.

a sustained decrease in general price level due to too little spending and investment

net exports may increase during deflation as deflation makes domestically produced goods cheaper than foreign imported goods

AD management

AS management

restrictive monetary policy: fall in supply of money relative to demand for money and increase in interest rate

open market sales of govt. securities to help absorb the liquidity in the system

increase the reserve ratio: -

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FISCAL POLICY: increase tax