4.8 - Inflation and Deflation

Question 1

Calculating the cost of a basket of goods

Answer 1

Price x weighting (weighting is decimal precentage, e.g. 24% = 0.34)

Question 2

Calculating CPI

Answer 2

(cost of basket / cost of basket in base year) x 100
to find percentage: -100

Question 3

How do you calculate the taxed percentage on products?

Answer 3

(taxed quantity / total amount) x 100

Question 4

Inflation

Answer 4

Inflation is the sustained increase in the general price level of goods/services in an economy

Question 5

Deflation

Answer 5

Deflation occurs when there is a fall in the general price level of goods/services in an economy

Question 6

Disinflation

Answer 6

Disinflation occurs when price growth slows down after a period of high inflation

Question 7

Demand pull inflation

Answer 7

Demand pull inflation is caused by excess demand in the economy
* If any of the four components of rGDP increase, there will be an increase in the total demand in the economy leading to an increase in the general price level

Question 8

rGDP

Answer 8

rGDP = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)

Question 9

Example of demand pull inflation

Answer 9

• If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms & consumers
  * This will result in an increase in consumption & investment which will increase the rGDP

Question 10

Cost push inflation

Answer 10

Cost push inflation is caused by increases in the costs of production in an economy
* If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in productivity, the total supply will decrease
* With less supply, prices rise leading to an increase in the general price level

Question 11

Example of cost push inflation

Answer 11

• Trade Unions negotiate higher wages for workers
• The wage increases represent an increased cost of production for firms
• With the inputs, firms now produce less & supply reduces leading to higher general price levels

Question 12

How does inflation impact firms? (3)

Answer 12

• Uncertainty: Rapid price changes create uncertainty & delay investment
• Menu change costs: Price changes force firms to change their menu prices too & this can be expensive
• Lenders: Financial firms that lend money are worse off as the money lent out is now worth less than before

Question 13

How does inflation impact consumers? (name 3)

Answer 13

• Purchasing Power: Decrease in purchasing power worsens their quality of life
• Savings: There is a decrease in the real value of savings (as money will be worth less in real terms)
• Real Income: There is a fall in real income for those on fixed incomes/pension
• Borrowers: anyone who borrows money benefits as the repayments are worth less than when the money was originally borrowed

Question 14

How does inflation impact the government? (3)

Answer 14

• International Competitiveness: Inflation erodes international competitiveness of export industries as their products now look relatively more expensive to foreigners
• Trade-offs: They are involved in tackling inflation e.g reducing inflation may increase unemployment and/or reduce economic growth
• Government Debt: inflation erodes the value of government debt as the repayments are worth less than when the money was originally borrowed

Question 15

How does inflation impact workers? (2)

Answer 15

• Higher Wages: Workers demand higher wages to compensate for reduced purchasing power
• Morale: If wage increases ≠ inflation, motivation & productivity may fall as workers do not receive the same real benefit for the work they are doing

Question 16

Demand-side deflation (bad deflation)

Answer 16

Demand-side deflation is caused by a fall in total (aggregate) demand in the economy
* If any of the four components of rGDP decrease, there will possibly be a decrease in the total demand in the economy leading to a decrease in the general price level

Question 17

Supply-side deflation (good deflation)

Answer 17

Supply-side deflation is caused by increases in the productive capacity of the economy
* This is brought about by any increase in the quantity/quality of the factors of production
* It effectively creates a condition of excess supply in the economy
* General price levels fall
* National output (rGDP) increases

Question 18

Consequences of demand-side deflation (name 3)

Answer 18

• With a decrease in output, fewer workers are required & so unemployment increases
• With falling output & rising unemployment, households lose confidence choosing to save instead of spend. Consumption falls & rGDP reduces even more
• Debt feels more burdensome as the value of any debt is worth more. Real cost of borrowing increase as real interest rates rise when the price level falls
• Falling output & falling prices cause firms to lose confidence & so they delay investment, further reducing rGDP
• Falling output & falling prices reduce the profits of firms. Some firms will be unable to continue & will go out of business
• Persistently falling prices can prove attractive to foreigners & the level of exports may increase (this helps offset some of the reduction in rGDP)

Question 19

Consequences of supply-side deflation (name 3)

Answer 19

• With a decrease in costs, the output of firms increases. More workers are required & so unemployment falls
• With rising output & falling price levels, households become more confident & consumption increasing - increasing rGDP even more
• Debt still feels more burdensome as the value of any debt is worth more
• Rising output & falling costs of production cause firms to gain confidence & increase investment, thereby increasing rGDP
• Persistently falling prices boosts international competitiveness & exports increase

Question 20

How can demand-pull inflation be tackled?

Answer 20

Using contractionary demand-side policies (monetary or fiscal)

Question 21

How does contractionary fiscal policy reduce demand-pull inflation?

Answer 21

1. Government increases corporation tax: Firms pay more tax → firms have less profit → firms invest less → rGDP falls → inflation decreases
2. Government decreases expenditure on national defence: Government spending decreases → defence firms receive fewer orders from the government → national output falls → inflation decreases
3. Government increases personal income tax: Households have less discretionary income → consumption decreases → national output falls → inflation decreases

Question 22

How does contractionary monetary policy reduce demand-pull inflation?

Answer 22

1. The Central Bank increases interest rates: Household repayments on existing loans rise → households have less discretionary income → consumption decreases → national output falls → inflation decreases
2. The Central Bank decreases the money supply by stopping quantitative easing: Firms receive less money from the sale of bonds → investment decreases → national output falls → inflation decreases

Question 23

How do supply-side policies reduce cost push inflation? (3)

Answer 23

1. The Government reduces regulation on the oil & banking industries: Regulations removed → costs of production decrease as firms no longer need to spend money meeting requirements → national output (total supply) rises → inflation reduces
2. The Government changes migration policies to allow more workers into the country: More workers move into the country → the price of labour (wages) falls → costs of production reduce for firms → national output (total supply) rises → inflation reduces
3. The Government builds a new rail network serving ports & airports: Speed & capacity of transport infrastructure is improved → costs of production decrease as firms benefit from the improvements → national output (total supply) rises → inflation reduces

Question 24

How can cost push inflation be tackled?

Answer 24

Using supply-side policies

Question 25

How can deflation be tackled?

Answer 25

Using expansionary demand-side policies (fiscal and monetary)

Question 26

How do expansionary fiscal policies reduce deflation? (2)

Answer 26

1. Government increases expenditure on national defence: Defence firms receive more orders from the government → total demand increases → deflation is improved/eliminated
2. Government decreases personal income tax: Households have more discretionary income → consumption increases →total demand increases → deflation is improved/eliminated

Question 27

How does expansionary monetary policy reduce deflation? (1)

Answer 27

The Central Bank lowers interest rates: Household repayments on existing loans fall → Households have more discretionary income → consumption increases → total demand increases → deflation is improved/eliminated