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What is the aim of price stability?

Maintaining a low but positive inflation rate over time


What is inflation

Refers to an increase in the GPL of g&s in an economy


What is deflation

Refers to a decrease in the GPL of g&s. Occurs when the inflation rate FALLS BELOW 0


What is disinflation

Refers to a decrease in the RATE of inflation, a slowdown in the rate of incr of the GPL of g&s


What is stagflation

Refers to the situation of high unemployment and rapid inflation with depressed level of output
e.g. in the 70s and 80s due to the oil crises


What does the Consumer Price Index (CPI) do?

- most common indicator used by govs to measure changes in the GPL
- it measures the change in the px of a fixed basket of cr g&s commonly purchased by the average hh in an economy in a specific year.


Limitations of CPI

- may not be representative of all hhs as the fixed basket of g&s may not be representative of every single hh's consumption patterns. consumption patterns may differ.
- CPI figures do not sufficiently track changes in consumption pattern as the basket of g&s used in CPI computation is updated only periodically. the basket may not be reflective of the typical g&s purchased by hhs over time
- changes in CPI do not take into account changes in the quality of g&s consumed. if quality improves, cost of living falls and the converse is true too.


What is "internal value of money"?

internal value of money is defined as the amount of real g&s that it can buy, i.e. the purchasing power of a given sum of money.
GPL incr --> purchasing pwr decreases
GPL decr --> purchasing pwr increases

*note: external value of money depends on exchange rate


what is demand-pull inflation?

occurs when AD is rising near or at the full employment level, causing upward pressure on prices


causes of dd-pull inflation?

- expansionary FP
- expansionary MP

- expectations of rising Ys or GPL

- relative inflation rates
- depreciation of dom currency
- changes in T&P of foreign crs (increases X)
- high ec growth rates of TPs


what is cost-push inflation?

caused by continuous increase in unit COP, for reasons not associated with incr in AD


causes of c-p inflation?

- imported inflation (caused by mkt conditions - dd&ss factors; depreciation of dom currency)
- negative supply shock
- wage-push inflation
- tax-push inflation
- profit-push inflation (firms exercise their mkt pwr, restricting o/p to raise pxs in order to maximise their own profits)


consequences of unexpected high inflation

macro effects
- INTERNAL EFFECTS: undermines LR EG & future SOL
---> erodes business confidence, I falls
---> since savings by hhs fall in real terms -> pp falls with the same sum of money -> discourages hhs savings -> hhs will choose to buy other gds that serve as stores of wealth e.g gold -> less funds available for firms' investment as savings decline -> I falls (recall that real i/r = nominal i/r - inflation rate)

- EXTERNAL EFFECTS: incr in relative inflation undermines ec competitiveness and ext stability
---> X becomes less px competitive in world mkts -> assuming dd for cty's X to be px elastic, there will be a MTP fall in Qd of X -> fall in X rev. PLUS px of M fall dd for M incr as dom crs switch from dom gds to M -> incr in M exp THEREFORE next X falls, worsen current acc balance, worsen BOP
---> decr in foreign investment & LT capital inflow: rapid incr in uCOP might reduce the expected RoR on investment in the cty and deter new foreign investors and existing investors may relocate
---> ST capital outflow (hot $ outflow): high inflation rates may lead to capital flight as speculators, anticipating a fall in exrs, sell currency A for currency B where the monetary situation is more stable, to avoid exchange losses

microec effects
- allocative inefficiency (sends inaccurate price signals in the market, leading to under or over-production of some g&s)
- arbitrary redistribution of Y
- firms may gain at the expense of crs


causes of deflation

decr in AD, bad
- comes with falling RNY and rising unN

incr in AS, good
- SR: lowered uCOP, possibly due to removal of min. wage legislation/ fall in px of key raw materials
- LR: lowered uCOP due to incr in Q&Q of resources, e.g. incr in L pdtivity due to investment in human capital/adoption of new tech/incr in size of L force


consequences of deflation

macro effects
---> in periods of falling AD, ability of pxs to adjust downwards helps to moderate the contraction of the ecy
---> SR: fall in C & I cause deflationary spiral; LR: fall in I means a lower rate of capital accumulation, limits the rate at which the ecy's pdtive capacity can expand in the LT
---> in periods of deflation, exp MP through i/r cuts could be rendered ineffective

---> improve BOT
---> deflation -> crs postpone consumption -> limited firms ability to incr pxs of final g&s -> expected RORI w/n the cty falls -> incr outflow & decr inflow of LT capital
---> dom currency appreciates