Inflation & Deflation

Question 1

Define cost-push inflation

Answer 1

Increasing costs of production that push up the average price level

Question 2

What causes higher costs of production

Answer 2

Wage costs 
Oil prices
Import prices
Exchange rate
Taxation
Wage price spiral —> inflation causes higher prices —> labour demand higher nominal wages which in turn increases costs of production

Question 3

What are the costs of inflation

Answer 3

Uncertainty —> firms less willing to invest —> uncertain about future prices, profits and costs
Fall in value of savings —> consumers savings will see a fall in the real value of their savings —> inflation higher than interest rates (savings will decrease)
Fall in value of debt —> reduce real value of debt —> consumers and firms pay back their debt easier
Reduced purchasing power —> nominal income doesn’t rise with inflation then consumers can buy fewer g/s
Shoe leather costs —> firms have to spend time looking for best prices from suppliers
Menu costs —> firms have to change price lists and labels
Fiscal drag —> incomes rise with inflation —> consumer may move into higher tax band —> no better off in real terms
Loss of international competitiveness —> domestic goods become relatively more expensive compared to foreign countries

Question 4

What are the costs of deflation

Answer 4

Decreases spending —> consumers delay purchasing in expectation of lower prices
Real value of debt increases —> deters businesses from borrowing
Interest rate effectively increases
Government debt as a % of GDP will increase (decreases real tax revenue but debt serviced stays the same)
Deflationary spiral —> falling prices and lower wages —> dampens AD (consumption and investment) and lower confidence