Unit 4 - Chapter 20 - Inflation

Question 1

what can be used to measure inflation

Answer 1

GDP deflator, CPI, PPI

Question 2

is GDP deflator a price, or an inflation rate

Answer 2

Price

Question 3

is CPI a price, or an inflation rate

Answer 3

price

Question 4

how to get GDP deflator?

Answer 4

(Nominal GDP / Real GDP) * 100

记得GDP deflator是用100来表达的

Question 5

why low inflation / stable inflation is desirable

Answer 5

• Certainty. It is easier to make decision related to the future, such as investment and receiving education.
• Indicate that there is a stable increase in aggregate demand. It encourages firms to expand, creating jobs.
• Wages will also have the opportunities to increase with prices
• As price level increases, the real value of debt decreases. It is beneficial for the borrowers so inflation encourages firms and individuals to borrow for investment and consumption. This will boost aggregate demand.

Question 6

define inflation

Answer 6

Inflation: a sustained increase in an economy’s price level.

When there is inflation, the value of money falls and its purchasing power declines

Question 7

define hyperinflation

Answer 7

Hyperinflation: an exceptionally high rate of inflation, which may result in people losing confidence in the currency, such as the case in Zimbabwe

This is often taken to be an annual inflation rate that exceeds 50% but it can go much higher.

Question 8

define deflation

Answer 8

Deflation: a sustained fall in the price level.

It results in a rise in the value of money, with each currency unit having greater purchasing power. Deflation involves a negative inflation rate, for example, –3% annually.

Question 9

what is disinflation

Answer 9

Disinflation: a fall in the inflation rate

Question 10

identifty the two ways we use to calculate the inflation rate

Answer 10

1. The annual average method. 把过去12个月物价平均一下。然后跟上一个12个月的物价对比
2. The year-on-year method。把当月的物价，跟去年同期的物价相比

Question 11

define CPI

Answer 11

The Consumer Price Index (CPI) is a weighted index of consumer prices in the economy over time. It is used to measure the cost of living for an average household.

Question 12

how to measure CPI

Answer 12

• S Survey: A sample of the population’s households are asked to keep a record of what they buy.
• C Categorize: The products purchased are placed into categories such as food and clothing and footwear
• W Weighting: Based on the proportion of total expenditure spent, weights are attached to the different categories. For instance, if on average households spend $500 of their total expenditure of $2,000 on food, the category will be given a weight of ¼ or 25%
• T Track: price changes are recorded
• Calcualte Weight * price: will give the latest consumer price index.

Question 13

what are the problems of using CPI to get inflation?

Answer 13

1. The base year is hard to determined
2. the survey may not be accurate
3. the basket may not be representative

Question 14

what are the problems of choosing a base year?

Answer 14

• In some cases, it can be difficult to select a base year. For instance, if a year is selected in which it is later found that inflation was unusually high, it may give the impression that subsequent percentage changes in the price level were unusually low.

Question 15

what are the problems of conducting a survey for the CPI?

Answer 15

• The people selected to keep details of their expenditure may not be representative. For instance, there may be a higher proportion of vegetarians who complete the survey than in the whole population. In this case, the weight given to vegetables will be disproportionately high
• The people selected may not report statistics accurately. They may make mistakes in recording their spending or may deliberately leave items out.
• Even if people are selected are representative, CPI is still **an average measure **. Different groups have different spending patterns and so effectively different inflation rates. For instance, elderly people may spend more than most on heating fuels and so would be affected more than the young by a rise in their price.

Question 16

what are the problems of the basket for the CPI?

Answer 16

• Substitution bias due to slow weight adjustment: Items in the basket of goods and services and the weights may be out of date. Consumers may react during this time to changes in relative prices by altering their purchases.
  
  • For instance, if pork rises in price by more than chicken, consumers may switch from buying pork towards buying chicken. As such, CPI over-estimates the true price level
• Basket outdated: The basket takes time to include new products and to remove old products that are becoming less popular. Each year, only a small number of new products are included and old ones eliminated.
  
  • For example, in 2019, the UK government added a relatively new electronic device, the smart speaker, to the basket, but it was also the first year that the well- established electric toothbrush was included.
• Quality bias: There is also a risk that the basket may have what is called a quality bias. A washing machine may rise in price by 4%, for instance, but it may have improved in quality, with additional features and a longer life. In such a case, it could be argued that consumers are getting better value for money.
• Quality bias2: Shrinkflation: It is also possible that while prices may not change, the quality and size of products may decline. For example, the price of a flight may stay the same but the quality of the meals served may decline, or the price of a bar of chocolate may not change but it could become smaller (sometimes called shrinkflation)

Question 17

consider if CPI measurement is always accurate?

Answer 17

Need to say the problems of choosing base year; the problems of survey; the problems of basket.

Then say:

• In low income countries, the construction of CPI will be even more difficult due to
  
  • A lack of well-trained staff
  • Financial difficulties to get accurate measure in time and frequently
  • A large proportion of informal economy, which makes tracking price changes more challenging

Question 18

identify the THREE causes of inflation

Answer 18

1. cost-push
2. demand-push
3. The monetarist: uncontrolled increase in money supply in order to pay for government deficit

Question 19

Explain cost-push inflation

Answer 19

Cost-push inflation occurs when prices are pushed up by increases in the cost of production.

For example, it occurs if

• Increase in wages > increase in labour productivity
  
  • Higher wages can cause a wage–price spiral. Workers gain a wage rise, which causes prices to increase, then workers seek higher wages to restore their real value and so on
• Increase in inflation expectation
• Increase in real material cost
  
  • which can be caused by a depreciation or devaluation in the exchange rate. So cost push inflation can be imported.

记得画AS-AD图来展示。文中要写，graphically, SRAS shifts up from SRAS1 to SRAS2, so that real GDP decreases from Y1 to Y2, and the price level increases from P1 to P2

Question 20

explain demand-pull inflation

Answer 20

Demand-pull inflation occurs when prices are ‘pulled up’ by increases in aggregate demand that are not matched by equivalent increases in aggregate supply.

记得画AS-AD图来展示。文中要写，graphically, AD shifts to the right from AD1 to AD2, so that real GDP increases from Y1 to Y2, and the price level increases from P1 to P2

Question 21

evaluate the cause of inflation

Answer 21

Not all demand-pull inflation is good
- A rise in aggregate demand will have a greater impact on the price level the closer the economy comes to full capacity.

Inflation can be temporary
- An increase in some forms of government spending and investment may not be inflationary in the long run. This is because, for example, government spending on education may raise labour productivity and so increase productive capacity.

Causes are not clear-cut
- Some changes will lead to both cost-push and demand-pull inflation. Demand-pull and cost-push factors may interact and reinforce each other and an inflationary spiral may develop. For example, a tax cut will boost consumption and investment. Greater investment raises the demand for raw materials such as cement, steel and oils, which leads to cost-push inflation.
- It is difficult to determine its cause of inflation in reality. For instance, wages and consumer expenditure may be increasing but it may be difficult to know which occurred first and so whether inflation is the result of demand-pull or cost-push factors.

Question 22

what can cause low inflation

Answer 22

1. drop in AD
2. increase in AS.

In recent years, SRAS grows because:
- Increasing global competition, which lowers the price of imports as each country exploits their comparative advantages. For example, US producers will be reluctant to raise price if they are facing fierce competition from cheap Asian imports.
- Advance in technology, which raises productivity and lowers production cost. Also, increasing use of automation reduce the demand for unskilled labour and reduce workers’ bargaining power, so that wages do not rise even if output increases.
- Weakened trade union influence in the US and in Europe. Trade union membership has fallen while there has been a growth in casual employment. These changes have reduced the ability of workers to call for wage rises

Question 23

identify the disadvantages of inflation

Answer 23

(1) Shoe leather cost: transaction cost
(2) Menu cost: need to change listed price more often
(3) Fiscal drag (bracket creep): pay higher tax bracket
(4) Discourage investment
(5) Inflationary noise (money illusion): Wrong signal, make wrong decisions
(6) Random redistribution of income
(7) A reduction in net exports
(8) Inflation causing inflation

Question 24

explain the disadvantages of inflation internationally

Answer 24

(1) Discourage investment (foreign direct investment)
Unanticipated inflation can create uncertainty and so make it more difficult for firms to plan ahead. This may dissuade foreign firms from investing, which will have an adverse effect on economic growth.

(2) A reduction in net exports:
Inflation may reduce the international competitiveness of a country’s products and so increase import expenditure and lower export revenue. This may result in balance of payments problems.

(3) The inflation may be caused by more expensive imported raw materials. This means CA will further worsen.

Question 25

explain shoe leather cost

Answer 25

• Shoe-leather cost is the time and effort you spend to minimize the effect inflation has on your finances.
• E.g. it takes time and labour to exchange domestic currency into foreign currency. Banks need to employ more to handle increased request

Question 26

explain menu cost

Answer 26

Menu cost arises from the need to change listed price more often

• For example, catalogues, price tags, bar codes and advertisements have to be changed.
• During the Brazilian inflation of the early 1990s, for instance, supermarket workers reportedly spent half of their time replacing old price stickers with new ones.
• Menu cost can be alleviated by tech advance because price can be changed electronically

Question 27

explain fiscal drag

Answer 27

Fiscal drag (bracket creep) occurs when people and firms are dragged into higher tax brackets if their income rises with inflation.
For example, a worker was earning $1000 a month before inflation. He argued for a higher wage at $1200 a month, as there is inflation.
If the income tax schedule is such that workers begin paying tax after a monthly income of $1000, he may have to pay income tax. This means the worker would have to start paying income tax.

• The more progressive the income tax system is, the greater the fiscal drag.
• It can be argued, however, that this is a cost of an inefficient tax system rather than a cost of inflation.

Question 28

explain how inflation discourages investment

Answer 28

Unanticipated inflation can create uncertainty and so make it more difficult for firms to plan ahead. This may dissuade firms from investing, which will have an adverse effect on economic growth.

Question 29

if the inflation is perfectly anticipated, would it discourage investment

Answer 29

A perfectly anticipated inflation means what happens to price level is fully taken into account. As a result, inflation does not create uncertainty. Firms can still set contracts and plan ahead, so it does not discourage investment.

Question 30

explain how inflation creates noise

Answer 30

Inflationary gives a wrong signal about prices, prompting economic agents to make wrong decisions.
This arises when inflation causes consumers and firms to confuse price signals. Inflation can make it difficult to assess what is happening to relative prices. For example, firms seeing the price of their products rising may increase output when the higher price is the result of inflation rather than increased demand for their products. This may result in a misallocation of resources.

• the more unanticipated inflation is, the greater the noise will be.

Question 31

explain why inflation creates random redistribution of income

Answer 31

Some people may gain and some people may lose as a result of inflation. For instance, if the rate of interest does not rise in line with inflation, borrowers will gain and lenders will lose. This is because borrowers will pay back less in real terms and lenders will receive less. Savers and fixed income earners will also lose out as the real value of their savings or income stream will fall.

Question 32

explain how inflation reduces net exports

Answer 32

Higher inflation relative to other countries causes the price of exports to increase, which reduces the quantity demanded for exports. If the demand for exports is price elastic, this means the quantity demanded will drop by a greater percentage compared to the increase in price. Export revenue will fall.
Similarly, inflation means domestic goods are more expensive. Imported goods are relatively cheaper. Assuming the demand for import is price elastic, import expenditure will rise.
In combination, inflation causes NX to drop, worsening current account. It also leads to a depreciation in the exchange rate.

• However, this only applies if the demand for exports and imports are price elastic. If the demand for a country’s exports is price inelastic, inflation will lead to an improvement in the CA instead.

Question 33

explain how inflation causes more inflation

Answer 33

Inflation may generate further inflation as consumers, workers and firms will come to expect prices to rise. As a result, they may act in a way that will cause inflation.
- For example, workers may press for higher wages, firms may raise prices to cover expected higher costs and consumers may seek to purchase products now before their prices rise further.

Question 34

Identify the benefits of inflation

Answer 34

(1) Stimulating output
(2) Prevent some unemployment
(3) Reduce the burden of debt

Question 35

why inflation stimulates output

Answer 35

A low and stable inflation rate caused by increasing demand may make firms feel optimistic about the future. In addition, if prices rise by more than costs, profits will increase, which will provide funds for investment. Real interest rate is lower, reducing the cost of investment.

Question 36

how inflation reduces unemployment

Answer 36

Inflation would enable firms to reduce the real costs of labour, as long as wages does not rise in line with inflation.
- Whether this is effective depends on the stickiness of wages. Workers with higher bargaining power can bargain for a higher wages when there is inflation.

Question 37

how inflation reduces the burden of debt

Answer 37

Real interest rates may fall due to inflation or may even become negative. This is because nominal interest rates do not tend to rise in line with inflation. As a result, debt burdens may fall. For example, those who have borrowed money to buy a house may experience a fall in their mortgage payments in real terms. A reduction in the debt burden may stimulate consumer expenditure that, in turn, could lead to higher output and employment.