Download 17.1 Inflation and Deflation

Inflation and Deflation
Chapter 12
Inflation
 The most common way of
measuring this in the UK is the
CPI
 When the rate of inflation is
published it means the
percentage increase in the CPI
over the previous 12 months
(annual inflation)
 When we learn micro
economics we see that prices
go up and down all the time
 In macro we are describing a
general movement of all prices
 The current CPI target is 2%
plus or minus 1%
 This diagram shows recent UK
data for both the RPI and the
CPI
 The CPI excludes housing
costs
Inflation: a
sustained
increase in the
general price
level
Insert fig 12.1
P136
Consumer Price Index: the
headline measure of inflation
derived from movements in a
weighted basket of consumer goods
over a 12 month period
The Consumer Price Index (CPI)
 The CPI is a weighted price
index used to measure the
change in the prices of a
typical basket of goods and
services
 The contents of the basket
are changed each year using
information from the Family
expenditure Survey
 Changes in weighting reflects
changes in spending
behaviour (the more that is
spent the higher the
weighting)
 In 2008 fruit smoothies,
muffins and USBs were
included in the basket
 Microwaves, 35mm camera
film and CD singles were
removed
Family Expenditure Survey: a
representative monthly survey of UK
household expenditure used to derive
changes in the CPI
Using index numbers
 This is straight forward if you
can calculate percentage
changes
 This table shows the made up
index of house prices
 2005 is the base year
 In 2006 there is an increase of
8.4% so the index goes up to
108.4
 In 2007 there is an increase of
20% since 2005 so the index is
120.0
 We need to take more care
when working out the
percentage change from 2006
to 2007
 It is not 11.6%
 It is (120-108.4)/108.4 x 100 =
10.7%
 (Difference between the two
years divided by the original
year)
Year
Index
2005
100.0
2006
108.4
2007
120.0
Limitations of the consumer price index as a measure of inflation
 Different population groups experience different rates of inflation
 The CPI is an average household and not representative of individual
households
 The weighting for tobacco or motoring expenses will be irrelevant for
non smokers and those without a car
 The CPI does not include house prices
 Mortgage prices will be a high proportion of spend of younger house
buyers
 Many older home owners will have paid off their mortgages
 The CPI may overestimate inflation
 Price rises may hide improvements in the quality of goods and services
 Cars and electrical goods may have gone up in price but this is due to
new innovations
Were you listening?!
• Why might the CPI not be a good index to
use?
Causes of inflation
 Inflation comes from several
sources
 It can come directly from the
domestic economy
 Price strategies of leading food
retailers based on the strength of
demand or competitive pressures
 A rise in VAT cause firm’s
production costs to go up and these
being passed onto the consumer
 It can come from external
sources
 Increase in price of crude oil or
other imported commodities,
foodstuffs and beverages
 Changes in exchange rates
 A falling pound against the Euro
might cause higher import prices
(remember WIDEC?)
Causes of inflation
 The two main categories of inflation are?
 Cost push and Demand Pull
 What is Cost push?
 Things that cause production costs to go up
and force firms to raise their prices to
maintain profit margins




A rise in costs of imported raw materials
Rising labour costs
Higher indirect taxes
Wage price spirals
 Draw a diagram illustrating cost push
inflation
 What is Demand pull?
 Most likely to occur when there is little spare
capacity in the economy
 Increase in AD will lead to an increase in
prices
 When does AD increase?
 When one or more of the components
increases
 Draw a diagram illustrating demand pull
 At A2 we add a third type – excessive
growth of the money supply
Insert diagrams on
P139
Quantity Theory of Money
 Devised by Irving Fisher to explain the
link between money and the general
price level
 Based on the Fisher equation or the
equation of exchange
 This is the mathematical identity which
relates aggregate demand to the total
value of output (GDP)
 M x V≡ P x T or (MV≡PY)
 M is the money supply
 V is the velocity of circulation (e.g. how
many times a £20 note is used to buy
goods and services in year)
 P is the general price level
 T stands for transactions and is
equivalent to output
 Y is the real value of national output
(real GDP)
Quantity Theory of Money:
the theory that increase in the
money supply will lead to
increases in the price level
Velocity of circulation: the
number of times the money
supply changes hands in a
year
Quantity Theory of Money
 Monetarists argue that the velocity of
circulation of money is broadly
predictable and therefore assumed to
be constant
 T and Y (real GDP) tends to increase
slowly over time and thus is assumed
to be constant in any one year
 If V and T (Y) are held constant then
changes in the rate of growth of the
money supply will lead directly to
changes in the general price level
 So as money supply increases so does
inflation
 http://www.youtube.com/watch?v=NiD9
FSp_tMw
Quantity Theory of
Money: the theory that
increase in the money
supply will lead to
increases in the price
level
Velocity of circulation:
the number of times the
money supply changes
hands in a year
Play duck inflation video
Consequences of inflation
Examiner’s tip: try to remember
 Low and stable inflation is often seen the detail of three or four costs for
as an indicator of a healthy economy consequences of inflation for your
 Hyperinflation indicates an economy Unit 4 exam
out of control
 There are a variety of consequences
 International competitiveness
 If inflation is higher in the UK than
other international competitors UK
goods and services will become
less price competitive (ceteris
paribus)
 Around 30% of the UK’s GDP is
generated by exports and a similar
value is imported
 The potential effect on growth,
employment and the balance of
payments is significant
 Exporting firms may need to make
redundancies and revenues will fall
 If X reduces X-I will reduce which
will reducing growth of AD and an
output gap
Consequences of inflation
 More consequences
 Effect on Investment
 Investment by firms needs future
certainty and optimism
 Inflation causes uncertainty of
costs, revenues and therefore
profitability
 Investment levels may fall
 Poor investment over time will
affect growth, employment and
the balance of payments
 Menu costs
 This is the administrative cost of
frequent changes in goods and
services
 These costs may be passed on to
the consumer contributing to cost
push inflation
Consequences of inflation
 More consequences
 Unanticipated inflation
 There is a difference between
anticipated (expected) and
unanticipated (not expected)
inflation
 If people expect inflation of 2%
but inflation is 4% there is
unexpected inflation of 2%
 This is what leads to
uncertainty that undermines
investment
 Unanticipated inflation is likely
to happen when inflation is
unstable and high which is why
the UK government tries hard
to keep it low and stable
Consequences of inflation
 More consequences
 Shoe leather costs
 When prices are rising consumers will spend
more time, effort and possibly money
shopping around
 This evokes the image of people pacing the
high street but in reality consumers and firms
are more likely to carry out the search by
telephone or the internet.
 Effect on distribution of income
 An important source of economic injustice
and social unrest
 Inflation creates winners and losers
 The winners are the borrowers whose future
payment is fixed
 The losers will be savers who have a variable
return for example pensioners who will see
their purchasing power fall
 The government could index link pensions
and benefits to make sure they are in line
with inflation
Consequences of inflation
 More consequences
 Worsening industrial relations
 Friedman’s comment is very melodramatic but it is
true that strikes can be widespread during periods
of inflation
 Workers feel that they are losing out and fight for
more pay
 Fiscal drag
 When ever you see the word ‘drag’ think about
something dragging behind
 This is about tax allowances being behind inflation;
it is not keeping up with inflation and people are
worse off
 If someone has a tax allowance of £5000 and
earns £5000 they will pay no tax
 If prices rise by 10% and income rises the same
amount that person will then be paid £5,500
 They will now be taxed around 20% of the £500
(£100) and therefore be worse off
 The chancellor can increase the tax free allowance
in line with inflation
‘Inflation tears at the
fabric of society and
sets up groups of
workers against one
another in increasingly
violent conflict’ – Milton
Friedman
Fiscal drag: increases
in the burden of
taxation when tax
allowances are not
increased in line with
inflation
Consequences of inflation




- Hyperinflation
Usually regarded as inflation in
excess of 1000% per year
The currency is effectively
destroyed and cannot be used
as a medium of exchange or a
store of value
The economic system would
resort to barter
See Zimbabwe video
Can inflation be a good thing?
 Allen says that low predictable
levels of inflation provide
psychological incentives for firms
and individuals
 At inflation rates of around 2%
workers see some rise in pay (in
money terms)
 Firms see revenues increasing
 This could be pure money illusion
 It is felt to be preferable to no price
increases
‘Creeping inflation
lubricates the wheels of
industry’ – G.C.Allen
Money illusion: when
economic agents fail to
realise that changes in
money values are not
the same as changes in
real values
Can inflation be a good thing?
 In reality 0% inflation and a 0%
wage is the same as 2% inflation
and a 2% pay rise
 Psychologically the second option
is preferred
 The target of 2% plus or minus 1%
suggest that
 It is difficult to hit a target with
any accuracy
 There must be reasons why
governments prefer gentle
inflation
 It is seen as equally bad if you
undershoot the target as it is to
overshoot the target
Deflation
There is good deflation and
bad deflation
 Good deflation (benign)
 This comes about from the
LRAS shifting
 Output will increase and
price levels with fall
 This assumes that AD
remains (ceteris paribus)
 This will also give a lower
level of unemployment
(derived demand for
labour from the increased
demand for goods and
services
Deflation – a persistent fall in the
average price level in the economy
usually measured with the CPI
(Consumer Price Index)
Benign deflation: falling prices
resulting from technological
advances across the economy
This diagram is technically
incorrect because it still shows
inflation (prices are above 0)
and there really is no diagram
to draw for deflation
Deflation
 Bad deflation (malevolent)
 This comes about from AD shifting
 A downwards shift of AD will result in
lower price levels but also lower
output (less growth)
 This could lead to an increase in
unemployment
 Demand for goods and services will
decrease
 Labour is a derived demand
 If people think prices will go down
they will put off consumption
 When they see prices fall this will
confirm their thoughts
 They will further put off consumption
and AD will keep falling
Malevolent
deflation: falling
prices resulting
from a significant
downturn in
economic activity
Deflation
 Japan has a problem with deflation for
more than a decade
 Banks collapsed due to bad debts and
bad investments in their own stock
market
 People built up precautionary savings
in case they lost their jobs
 This depressed consumption and AD
 Interest rates were cut to 0.25% but it
didn’t work
 The damage had been done
 Consumer and business confidence
crumbled with people and firms
reluctant to spend
 Don’t confuse deflation with a falling
rate of inflation (this is called
disinflation)
Deflation/Disinflation
 From 1999 to 2000 the inflation rate
rose from 1.2% to 1.6%
 From 2000 to 2001 the inflation rate
fell from 1.6% to 1.3%
 the average level of prices rose
but at a lower rate than the
previous year – disinflation
 In the next two years the inflation rate
continued to fall (prices were still
rising but by a smaller and smaller
amount)
 In 2004 the country started to
experience deflation (the average
level of prices fell by 0.5%)
 From 2004 to 2005 the country was
still in a period of deflation where
average prices fell by 0.3%
Do you understand?
 Which period of time did Japan experience
a) Inflation
b) Disinflation
c) deflation
Costs of Deflation
 Although consumers may be pleased with falling
prices there are many problems with deflation
 Deflation is also a bit of an unknown so it is more
difficult to deal with than inflation
 Some economists argue that the costs of deflation
are higher than inflation
 Unemployment
 If AD is low businesses may lay off workers
 If prices fall consumers will put off purchasing
 Firms will have to drop prices to encourage
consumption
 Consumers will again put of purchasing believing
that prices will fall further (deferred consumption)
 Consumer confidence drops further depressing AD
 This is known as a deflationary spiral
 Investment will also be put off
Costs of Deflation
 Costs to debtors
 Anyone who has taken
a loan (including house
buyers who have taken
a mortgage) suffers
from deflation because
the value of their debt
rises
 If profits are low
businesses will find it
difficult to pay back
loans
 There may be many
bankruptcies
 This will make business
confidence even worse
Play Japan
Inflation video
Abenomics
 Japan is now determined to get out
of deflation
 They are dong something called
Abenomics
 This is basically mass Quantitative
easing
 http://www.youtube.com/watch?v=c
JKspInAYsY
 http://www.youtube.com/watch?v=
Njp8bKpi-vg