inflation

Section 18

A Low and Stable Rate of Inflation

Define Inflation

A persistent increase in the average price level of the economy, usually measured through the calculation of a consumer price index

Costs of Inflation (the reasons governments want to keep inflation low and stable)

Loss of Purchasing Power	Loss of purchasing power- if the inflation rate is higher than your rate of wage increase you will experience a loss of purchasing power -          People on fixed incomes or people without COLAS built into their contracts will suffer -          Also the role of expectations is important because wage contracts are agreed to in advance of inflation data
Effect on Savings	If the rate of inflation is higher than your interest rate you will experience negative savings. -          Inflation discourages savings though you can offset the effect on savings by purchasing assets whose value rises faster than inflation.
Effect on Interest Rates	Effect on interest rates- high rates of inflation cause banks to raise their nominal interest rates to avoid losing profits from lending money.
Effect on international competitiveness	A high rate of inflation causes a negative balance of trade -          Exports are less competitive and unemployment in export industries may result -          Imports from lower inflation trading partners become attractive
Uncertainty	Inflation causes reduced investment due to the fall in available loanable funds savings, higher interest and uncertainty in the marketplace, this negatively affects economic growth.
Labor Unrest	If labor does not feel their wages are keeping up with inflation it may cause disputes between unions and management

Define Deflation

A persistent fall in the average level of prices in the economy Good- results from the improvements in the supply side of the economy and/ or increased productivity Bad deflation- results from decreased aggregate demand. If output reduces it is assumed that the level of unemployment will wirse because firms will need fewer workers to produce less output

Good Deflation (improvements in the supply side of the economy)

 

                                       

Bad Deflation (source in demand side of the economy)

Disinflation

A slower rate of growth and inflation

Costs of deflation

Unemployment	When AD is low , business are likely to lay of workers and can lead to a deflationary spiral. -          If prices are falling consumers may delay purchases (deffered consumption), reduce AD and lead to lay offs. This in turn lowers consumers confidence and process repears
Effect of Investment	During deflation businesses make less profit or experience losses causing them to lay off workers and reduced investment
Costs to Debtors	Anyone who has taken a load suffers because the value of debt rises as a result of deflation

How is inflation measured? CPI/RPI

Choose rep. basket of consumer goods or services

Price of sample

Measure monthly by collectors from retailers

Catergorized and weighted

Issues (Limitations) involved in the measurement of inflation

Typical Market Basket	Basket not applicable for all people
Collection Errors	Errors in the collection of data
Market Basket Changes Affect comparisons over time	Differences counted by making changes in the market basket
International collection differences	Different countries measure inflation in different ways
Un-sustained price changes	Price may not change for a varety of reasons that cannot be sustained
Other Measures Value	Only measures changes in consumer prices

Causes of Inflation:

Demand-pull inflation

 

Cost-push inflation

 

Demand-pull and cost-push inflation together (Inflationary spiral)

 

Monetarist viewpoint (Inflation due to excess monetary growth)

 

Reducing Inflation (depends on type)

Reducing Demand-Pull Inflation

1.using deflationary fiscal policy:increase taxes or reduce gov. spending

2.deflationary monetary policy increase the prime interest rate, decrease the money supply

Problems with deflationary AD policies

1.raising taxes is unpopular

2.reducing gov spending impacts a variety of groups and may result in less support for the gov.

3.higher interest rates hurt home owners making mortgages more expensive

4.governemts worried about reelection will be reluctant to use these methods to reduce AD

Widely accepted (best) way to reduce demand-pull inflation:

Using monetary policy to lower AD carried out by central but def mon. pol. Increase I lower Ms

Why?

Central bansks not politically motivated

Reducing Cost-push inflation

Supply-side policies (market-based) [Why not interventionist?]

1.labour market reform

2.privatization

3.deregulation

4.increase competition

5.decrease corp taxes

6. decrease household taxes

Reducing inflation Monetarist Viewpoint:

The solution is to increase money supply at the same level of growth

Problems facing governments:

Trade-off between different policy objectives.

Inflation - unemployments

Difficulty in distinguishing the type of inflation.

Calculating Inflation

Non-weighted/equal weighting/weighting

Inflation Rate =

Inflation-unemployment trade-off debate

The Phillips Curve

Presented by New Zealander economist:

Based on a UK study of the economy from:

Stated:

Low unemployment → firms pay higher wages to attract labor

Unemployment high → workers compete to obtain jobs so wages relatively low

Showed inverse relationship between rate of change of wages and unemployment rate. The rate of change of wages could actually become negative in times of high unemployment.

Original Phillips Curve

 

Concept expanded by other economist to correlate it with inflation rate and unemployment rate using data from other countries.

Phillips Curve

 

Phillips Curve using AD/AS analysis

 

Long-run Phillips Curve