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Chapter 31 - Inflation & Deflation - CIE IGCSE & O Level

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Published in: Economics
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Revision summary of Chapter 31 - Inflation & Deflation of the CIE IGCSE & O Level coursebook.

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  1. INFLATION & DEFLATION CHAPTER 31 'Ill
  2. Learning Objectives Employment & Unemployment • define inflation and deflation • describe how inflation and deflation are measured analyse the causes of inflation discuss the consequences of inflation • discuss the effectiveness of policies available to control inflation analyse the causes of deflation • discuss the consequences of deflation • discuss the effectiveness of policies available to counter deflation explain possible policy conflicts
  3. THE STEPS TO MEASURING INFLATION DEFLATION) Selecting a base year A base year is a year in which no significant changes to the level of inflation were observed • It's given a value of 100 Finding out how households spend their money Only products which the bulk of households spend their money on should be considered Examples include groceries, water, electricity and fuel To find these out, govts carry out surveys; from these, they find out which items households spend their money on and what weight to attribute to each individual item Finding out price changes This info is collected from the providers of each item (product or service), such as grocery stores, energy providers and travel companies Constructing a weighted price index Having assigned weights to different items included in the index and measured the change in their prices over time, the final stage is to multiply the weights by the new price index for each category of products and to calculate the change in general price level.
  4. COST-PUSH INFLATION Occurs when the price level is pushed up by increases in the costs of production. Costs may increase due to increases in wages (in relation to productivity), and in the price of other factors of production. Firms will then pass higher costs onto customers (bear elasticity in mind) in the form of higher prices As overall cost of living increases, workers will start demanding higher wages, further contributing to inflation; therefore, its a wage-price spiral Price level ASI AS AD Quantity
  5. DEMAND-PULL INFLATION Occurs when the price level is pulled up by an excess demand, caused by an increase in either one or a combination of its components. Note: excess demand means that an increase in demand will only cause inflation it it is not matched by an equal shift in AS price level AD AS AD Real GDP Monetary inflation: rises in the price Level caused by an excessive growth of the money supply.
  6. THE HARNFUL EFFECTS OF INFLATION It creates uncertainty It makes it difficult to plan ahead, as households and firms will be uncertain about future prices Harms balance of payments If a country's inflation rate is above that of its rivals, its products will become less price competitive. This may result in a fall in export revenue and a rise in import expenditure Fiscal drag occurs when governments do not adjust tax brackets in line with inflation people's incomes are dragged into higher tax brackets and they are left with lower real disposable income. Devalues money The higher the inflation rate, the greater will be the fall in the purchasing power of money Redistributes income If the rate of interest is below the inflation rate, borrowers pay back Less in real terms than what they borrowed Extra costs on firms Menu costs: costs involved in having to change prices as a result of inflation. Shoe-leather costs: costs involved in moving money around to gain high interest rates.
  7. THE BENEFITIAL EFFECTS OF INFLATION It may encourage firms to expand low and stable level of demand-pull inflation may make entrepreneurs optimistic about future sales. Reduces the real burden of debt As any borrowed money will be paid back in nominal terms. It can prevent some workers being made redundant in a declining industry or region Whilst workers are likely to resist any cut in their money wages, they may accept their money wages rising by less than inflation
  8. NEASURES TO CONTROL INFLATION Holding the central bank accountable If a central bank does not achieve its target, it has to explain why and what measures it is going to take to get the inflation rate back on target Contractionary fiscal & monetary policy In the case of demand-pull inflation, the govt may raise taxes and decrease its expenditure, or increase the interest rate in order to dissuade spending, encourage saving and consequently contract demand Supply side policies In the case of cost-push inflation, the govt may invest in training and education to improve workers' productivity and hence decrease costs of production
  9. DEFLATION CAUSES Supply-side: price level may be reduced as a result of advances in technology and increases in labour productivity. This is a beneficial kind of deflation (good deflation) Demand-side: price level may fall due to a fall in AD. This is harmful (bad deflation), as it has negative spill over effects on the economy CONSEOUENCES Good deflation: may reduce a current account deficit or increase a current account surplus if demand for exports and imports is elastic and if the fall in the price level is not offset by a rise the exchange rate. Good deflation can be associated with increases in output and employment. Bad deflation: is likely to cause a rise in unemployment and lower output. It is also likely to discourage investment which will reduce productive capacity and endanger future economic growth POLICIES TO CONTROL IT Expansionary fiscal or monetary policy.
  10. POLICY CONFLICTS LOU UNEMPLOYMENT VS INFLATION • I.e., an increase in government spending on pensions would raise consumer expenditure. This rise would encourage firms to expand their output and take on more workers BALANCE OF PAYMENTS VS ECONOMIC GROWTH • I.e., rise in income tax, designed to reduce households' expenditure on imports, would also reduce spending on domestically produced products. This fall in demand will reduce the country's output or at least slow down the economic growth.
  11. You should know... The consumer prices index (CPI) is a weighted measure of consumer prices. A rise in a consumer prices index indicates inflation. Surveys are done of the products bought by households. On the basis of this information, weights are attached to products. The greater the percentage of an average household's total expenditure devoted to a product, the higher its weightage. • Information on price changes is found from a range of outlets. • A weighted price index is constructed by multiplying weights by a price index for each category. • A weighted price change can be found by multiplying weights with price changes. • Inflation may be caused by increases in the costs of production (cost-push), excess demand (demand-pull) or the faster growth of money supply relative to output (monetary). Among the causes of cost-push inflation are rises in wages and raw material costs.
  12. You should know... Demand-pull inflation is more likely to occur when the economy is at or approaching full employment. The effects of inflation will depend on its rate, stability of price rises, its rate relative to other countries and response of the government. • Inflation will cause a fall in the purchasing power of money. Among the other possible harmful effects are an unplanned redistribution of income, menu costs, shoe leather costs, uncertainty and a worsened position of the balance of payments. The possible beneficial effects of inflation include a stimulus to production, a reduction in debt and reduction of unemployment. The effects of deflation are influenced by whether it is 'good' deflation or 'bad' deflation. Economic growth and employment are likely to benefit from measures designed to increase aggregate demand but these measures may result in higher inflation and a rise in imports.

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