Inflation

Question 1

What is inflation?

Answer 1

A persistent or continuing increase in the level of prices in an economy

Question 2

What is deflation?

Answer 2

A persistent or continuing fall in the level of prices in an economy

Question 3

What is disinflation?

Answer 3

When the rate of inflation is rising but less than before

Question 4

What does the consumer price index measure?

Answer 4

Changes in the cost of living of a typical household

Question 5

How is the consumer price index measured?

Answer 5

• weighting are placed on items based on their importance
• prices for 600 items are compared to give the final result

Question 6

What is the inflation rate?

Answer 6

The annual percentage change in the consumer price index

Question 7

What is the target inflation rate?

Answer 7

2%

Question 8

What is price stability?

Answer 8

A sustained period of low and stable inflation

Question 9

What are some issues with the measurement process of CPI?

Answer 9

• changes in quality are not taken into account
• special offers and second hand goods aren’t taken into account
• weightings will lag behind any changes in spending patterns

Question 10

What is demand pull inflation?

Answer 10

When aggregate demand is growing at an unsuitable rate, leading to increased pressure on scarce resources and a positive output gap

Question 11

When does demand-pull inflation become a threat?

Answer 11

When an economy has experienced a boom with GDP rising faster than the long run trend growth of expected GDP

Question 12

When is demand pull inflation most likely to occur?

Answer 12

When there is full employment of resources and SRAS is inelastic

Question 13

What are the main causes of demand pull inflation?

Answer 13

• low cost and increased availability of credit
• consumer confidence
• expectation on the economy
• depreciation of the exchange rate
• reduction of tax
• wealth effect
• disposable income

Question 14

What is cost push inflation?

Answer 14

When firms respond to rising costs by increasing prices to protect their profit margins

Question 15

What are the causes of cost push inflation?

Answer 15

• rising unit labour costs
• natural disasters
• depreciation in exchange rates: cost of imports will increase
• corporation tax
• expectations
• external shocks (commodity price fluctuations, acceleration in wages)

Question 16

What are the costs of high inflation?

Answer 16

• lower purchasing power of money: makes households worse off
• erosion of savings (shoe leather costs); could mean a fall in living standards for those who live off of their savings eg pensioners, economically inactive, people begin to save less
• Lower export competitiveness: demand for exports will go down, worsening the current account position
• wage price spiral: as workers anticipate high inflation, they will bargain for higher wages. Cost of production (for firms) will increase. Extra costs will be passed down to consumers (causing higher prices). This increases inflation. Worker will then ask for higher pay rises (this create a cycle)
• consumer price spiral: when consumers anticipate high inflation, they bring forward their consumption by acting rationally and buying now to protect themselves from a future increase in price. This increases demand pull inflation
• fiscal drag: inflation is rising and workers are receiving higher income only in line with inflation. If workers get dragged into a higher tax band in a progressive income tax system they actually become worse off and their living standards decrease.
• ## inflationary noise: when the inflation rate is volatile (malleable). The price signalling function of market forces loses its value and significance. There is uncertainty in the economy; consumers put off their consumption, firms put off their long term investment plans - can hold back C and I and not help the economy to grow

Question 17

What happens during a wage price spiral?

Answer 17

1. Inflation rises
2. Real incomes fall
3. Workers bid for improved wages
4. Leads to high labour costs
5. Firms raise their prices

Question 18

What happens during hyperinflation?

Answer 18

1. Inflation goes out of control
2. Huge amounts of money have to be printed to meet peoples demand for cash
3. Money rapidly loses its worth
4. There is a collapse in business and consumer confidence
5. (Almost always) a new monetary policy will need to be created

Question 19

When do price levels usually rise?

Answer 19

• when exports are low
• during economic growth

Question 20

When do price levels usually fall?

Answer 20

• demand is low
• during a boom

Question 21

What are the benefits of a low and stable inflation rate

Answer 21

• workers with higher wages
• consumption is natural (it will not be brought forward or delayed)
• firms are encouraged to increase output (because they can raise their prices and earn more revenues)
• can keep unemployment low in a recession
• reduces the real value of debt
• improvement of government finances (governments get a fiscal windfall) more VAT revenue as prices rice, benefits of extra taxation from fiscal drag

Question 22

Which type of inflation causes benefits to outweigh the costs of high inflation?

Answer 22

Demand pull

Question 23

What is stagflation?

Answer 23

Stagnant economic growth
High inflation

Question 24

What are shoe leather costs?

Answer 24

The extra time, effort and inconvenience people go through to manage their money when inflation is high
- making more trips to the bank (so its not just sitting there, losing value)
- buying things more quickly (because of fear the price is going to further rise)

Question 25

What are menu costs?

Answer 25

The extra time, effort and changes that businesses need to make when they increase their prices

Question 26

When does demand side deflation occur?

Answer 26

When AD shifts to the left

Question 27

When does supply side (good) deflation occur

Answer 27

When SRAS shifts to the right

Question 28

How does demand side deflation negatively affect the economy?

Answer 28

- comes with lower growth - long-term and anticipated

Question 29

How does supply side deflation (good deflation) positively affect the economy?

Answer 29

- comes with higher growth - short-term and unanticipated

Question 30

What happens in a deflation spiral?