inflation: sustained increase in general price level (also provides a signal as to how the economy is performing)

measurement: price index
-consumer price index (CPI) measures the average price change in a fixed basket of goods over time
-producer price index (PPI) measures the price of raw materials and intermediate goods purchased by producers
-GDP deflator measures the changes in an economy's average price level (ratio of nominal GDP to real GDP)

causes of inflation

demand-pull inflation: originate from an autonomous increase in aggregate demand such as C, I, G or net X
-originate from monetary factors caused by expansionary monetary policy of the banking system

cost-push inflation: persistent increase in costs of production for reasons not associated with AD
-import price pushes: increase cost of production
-increase in structural rigidities: prevent efficient reorganisation of resources
-wage-push: workers demand for higher wages, prices also rise, causing wage-price spiral
-currency depreciation: makes imported raw materials more expensive in terms of domestic currency, higher costs of production
-supply side shocks: short term vs long term
-profits push: due to monopoly power of firms, prices are generally higher

effects of inflation

whether inflation is anticipated or not (if anticipated, effects are relatively small, people can make accurate predictions)

extent of inflation (severe vs mild)

on investment: adds uncertainty, firms are uncertain about future prices of their inputs and outputs due to an increase in risk and are deterred from investment.

severe inflation: businesses will hoard raw materials and products in anticipation of future price change, decreases availability of resources, intensify inflation.

mild inflation: stimulates investments as rates of returns increases, higher levels of outputs, indication that the economy is growing healthily. positive expectations for the future and firms invest more.

on net exports: if there is inflation in one country and not in the other, it is more difficult to sell the imports as the price has increased, fall in net exports. currency value decreases (depreciation)

on allocative efficiency: distortions in relative prices, result in misallocation of resources. structural rigidities cause prices to increase in different rates, not reflecting demand, misallocation, allocative inefficiency

on welfare: less purchasing power, lower economic aspect of welfare, higher income inequality. low income households are forced to work harder, less leisure time, lower qualitative aspect of welfare

menu cost: restaurants and firms have to keep adjusting prices, incur costs (printing of paper)

shoe-leather costs: people want to keep as little as possible, and makes frequent trips to the bank, causes shoes to wear and tear

on fixed nominal income receivers: income gap widens as their nominal income does not increase with inflation


on flexible income receivers: nominal income spurts ahead of price level, real income are enhanced


on savers: lose as the amount saved before holds less value now


on debtors and creditors: creditors lose while debtors benefit, the amount borrowed in the past is cheaper now

deflation: sustained decrease in general price level

causes

originate from an autonomous decrease in AD or an autonomous increase in AS

decrease in AD may also originate with monetary factors, caused by contractionary monetary policy of banking system

arise from supply side/ cost side of market when there is a persistent decrease in cost of production for reasons not associated with AD (aka cheaper imports, currency appreciation)

effects

consumers expect future prices to continue to be lowered and choose not to spend; they might be pessimistic about the future and expect the wages to fall, remaining cautious about spending.

less demand, firms lower prices and reduce production, reducing business confidence, decrease in investments.

firms demand less labour, increase in unemployment rate.

increases real burden of debt, leading to bankruptcy

some price declines reflect efficient adjustment in relative price levels and could signal the need for reallocation of resources

increase in net exports as goods are relatively cheaper