4.2.3.3 Inflation and Deflation

Question 1

Inflation Definition

Answer 1

Rate of Change in the average price level over time

Question 2

Deflation Definiton

Answer 2

A Decrease in the general level of prices

Question 3

Disinflation Definition

Answer 3

When the rate of inflation is falling, but still positive. Prices are rising slower than previously

Question 4

Demand Pull Inflation

Answer 4

A situation where aggregate demand exceeds aggregate supply leading to an increase in the general level of prices

Question 5

Cost Push Inflation

Answer 5

A situation where increased costs of production lead to firms increasing their final prices, leading to a rise in the general level of prices

Question 6

Retail Price Index

Answer 6

A measure of inflation including interest payments on mortgages and council tax

Question 7

Consumer Price Index

Answer 7

A measure of inflation used by the Bank of England to set inflation targets, and measure inflation across the EU

Question 8

Creeping Inflation Definition

Answer 8

Slow rises in prices over a number of years

Question 9

Hyper-Inflation Definition

Answer 9

Large increases in the general price level, when the store of value function of money fails to hold

Question 10

Limitations of CPI

Answer 10

• Households experience different rates of inflation
• Doesn’t recognise improvements in quality of goods and services
• Slow to respond to new products

Question 11

Retail Prices Index

Answer 11

• Includes Mortgage Interest Repayments and Council Tax
• Tends to be above the CPI
• Excludes top and bottom 4% of the population
• Discredited as a measure because mortgage payments distort the figure

Question 12

CPIH

Answer 12

• Adds owner-occupier housing costs and council tax to CPI
• Otherwise the same basket as CPI

Question 13

Causes of Demand Pull Inflation

Answer 13

• Reduced taxation
• Lower Interest Rates
• Confidence - increases consumption and investment
• Income Increases
• Availability of Credit
• Fast Growth in Other Countries, increase demand for UK exports

Question 14

Causes of Cost Push Inflation

Answer 14

• Wage Increases, wage-price spiral
• Higher Raw Material Costs
• Higher Taxes - corporation, national insurance, waste disposal
• Higher Import Prices
• External Shocks

Question 15

What is Quantitative Easing

Answer 15

An unconventional form of monetary policy involving the introduction of new money into the national supply by a central bank

Question 16

Quantitative Easing sequence

Answer 16

1. New Electronic Money is created by the Central Bank
2. This is used to buy assets
3. Increases the Price of Bonds
4. Bond yields fall
5. Financial institutions, having sold bonds now have more liquidity
6. Greater Liquidity may incentivise financial institutions to lend more
7. Lower Yields mean Lower Interest Rates
8. More and Cheaper credit so C and I rise
9. As bond and asset prices rise, positive wealth effect
10. Lower Interest Rates leads to a depreciating currency so (X-M) rises
11. AD should rise

Question 17

Wealth Effect

Answer 17

Lower yields lead to higher share and bond prices

Question 18

Borrowing Cost Effect

Answer 18

QE lowers the interest rate on long term debt such as government bonds and mortgages

Question 19

Lending Effect

Answer 19

QE increases the liquidity of banks and increased lending from banks lifts incomes and spending in the economy

Question 20

Currency Effect

Answer 20

Lower interest rates has the side effect of causing the exchange rate to weaken (a depreciation) which helps exports

Question 21

Fisher Equation

Answer 21

MV = PQ

M = money Supply
V = Velocity of Circulation (how many times money circulates around the economy)

P = Average Price Level
Q = National Income/Output/Expenditure

Question 22

Problems with the Quantity Theory of Money

Answer 22

Other possible causes of inflation include:
- Changes in V
- Changes in Q
- Demand-pull and Cost-push inflation

Other Issues:
- Reverse Causality
- M difficult to quantify

Question 23

Costs of Inflation

Answer 23

• Reduced Confidence and therefore investment
• Real value of savings decreases - disincentive to save
• Income redistributed from savers to borrowers - real value of debt falls
• Consumers and Businesses on fixed incomes lose out
• Harms Trade (Reduce UK competitiveness)
• Wage-Price Spiral
• Higher Interest Rates
• Menu Costs and Shoe Leather Costs (Prices associated with constantly changing prices e.g. reprinting menus and the cost of shoe leather as people have to walk up and down to find the best prices)

Question 24

Benefits of Inflation

Answer 24

• Sustainable rate of inflation suggests growth
• Reduced risk of Deflation
• Erodes the Real Value of Debts

Question 25

Consequences of Deflation

Answer 25

- Consumers hold back on spending as they expect prices to drop further - Real cost of borrowing increases, so debts increase - Lower profit margins - Wealth decreases and hits confidence - business investment can decrease

Question 26

Types of Deflation

Answer 26

Malign (Bad) Deflation due to a decrease in AD Benign (Good) Deflation due to a Outward Shift in SRAS

Question 27

How Foreign Changes affect Domestic Inflation

Answer 27

- Commodities make up a large proportion of UK imports and therefore have a big impact on prices - Imported Commodities are inelastic, so a rise in the World price of commodities feeds through to UK inflation - Emerging Economies can create growing demand for UK exports, demand pull inflation - Increasing productive capacity in emerging economies leads to lower costs of production and lower prices - Economic performance of major trading partners impacts on demand and therefore inflation