Low and Stable rate of inflationIB Economics

InflationInflation is what?A persistent rise in average prices in the economy (learn this!!)How is it measured?Normally using the CPI – Consumer Price IndexWhat is the inflation target?Depends on the countryThe UK is 2% CPIWatch inflation videoShow how prices have changed over the years

Inflation – a persistent increase in the average price level in the economy usually measured with the CPI (Consumer Price Index)

Why worry about inflation?There are a significant number of negative consequences associated with high levels of inflationLoss of purchasing power

If the rate of inflation is 2% the average price of all goods and services in the economy has risen by 2%

If your salary/wages stays the same then it means you can buy less goods and services

Your purchasing power (the amount you can buy) has been reduced

In this case we say that you have had a fall in real income (income adjusted for inflation)

Why worry about inflation?Loss of purchasing power

If your income was linked to the inflation rate you would automatically get a 2% cost of living increase which means your real income has remained the same

If you worked for a company that had a strong union this may be the case but lots of people do not have inflation linked incomesSelf employed, weak trade unions,

fixed incomes (old people on pensions/unemployed on benefits)

Expected rates of inflation are important

If your company expects 1.5% inflation and gives you an increase of 1.5% but then the inflation rate turns out to be 2% your purchasing power will have reduced

Why worry about inflation?Effect on savingIf you save $1000 in the bank at 4% annual interest you will end up with $1,040If the inflation rate is 6% then the real rate of interest (the interest rate adjusted for inflation) will be negative (4% - 6% = -2%)Your savings will not buy as much as they did the year beforeYou would have been better to spend it than save itYou will have lost purchasing powerInflation therefore discourages savingPeople will buy assets such as houses or art which will be worth moreAs the bank uses savings to lend to others – less saving will mean less funds for investmentThis may have negative implications for growth

Why worry about inflation?Effect on Interest RatesCommercial banks make money from charging interest to people who borrow moneyIf there is a high rate of inflation banks will raise their interest rates to keep the real rate that they earn positiveEffect on international competitivenessIf a country has a higher rate of inflation than its trading partners its exports will be less competitiveImports from lower-inflation countries will be more attractiveThis may worsen the balance of paymentsThis could lead to unemployment in export industries and industries that compete with imports

DeflationThere is good deflation and bad deflationGood deflationThis comes about from the LRAS shiftingOutput will increase and price levels with fallThis assumes that AD remains (ceteris paribus)This will also give a lower level of unemployment (derived demand for labour from the increased demand for goods and services

Deflation – a persistent fall in the average price level in the economy usually measured with the CPI (Consumer Price Index)

DeflationBad deflationThis comes about from AD shiftingA downwards shift of AD will result in lower price levels but also lower output (less growth)This could lead to an increase in unemploymentDemand for goods and services will decreaseLabour is a derived demandIf people think prices will go down they will put off consumptionWhen they see prices fall this will confirm their thoughtsThey will further put off consumption and AD will keep falling

Deflation Japan has a problem with deflation Banks collapsed due to bad debts and

bad investments in their own stock market

People built up precautionary savings in case they lost their jobs

This depressed consumption and AD Interest rates were cut to 0.25% but it

didn’t work The damage had been done Consumer and business confidence

crumbled with people and firms reluctant to spend

Don’t confuse deflation with a falling rate of inflation (this is called disinflation)

Deflation/Disinflation From 1999 to 2000 the inflation rate

rose from 1.2% to 1.6% From 2000 to 2001 the inflation rate

fell from 1.6% to 1.3% the average level of prices rose

but at a lower rate than the previous year – disinflation

In the next two years the inflation rate continued to fall (prices were still rising but by a smaller and smaller amount)

In 2004 the country started to experience deflation (the average level of prices fell by 0.5%)

From 2004 to 2005 the country was still in a period of deflation where average prices fell by 0.3%

Do you understand? Which period of time did Japan experience

a) Inflation

b) Disinflation

c) deflation

Costs of Deflation Although consumers may be pleased with falling

prices there are many problems with deflation Deflation is also a bit of an unknown so it is more

difficult to deal with than inflation Some economists argue that the costs of deflation

are higher than inflation Unemployment If AD is low businesses may lay off workers If prices fall consumers will put off purchasing Firms will have to drop prices to encourage

consumption Consumers will again put of purchasing believing

that prices will fall further (deferred consumption) Consumer confidence drops further depressing AD This is known as a deflationary spiral Investment will also be put off

Costs of Deflation Costs to debtors Anyone who has taken

a loan (including house buyers who have taken a mortgage) suffers from deflation because the value of their debt rises

If profits are low businesses will find it difficult to pay back loans

There may be many bankruptcies

This will make business confidence even worse Play Japan

Inflation video

Measuring Inflation - The Consumer Price Index (CPI)

The CPI is a weighted price index used to measure the change in the prices of a typical basket of goods and services

The contents of the basket are changed each year

In the UK they use information from the Family expenditure Survey

Changes in weighting reflects changes in spending behaviour (the more that is spent the higher the weighting)

In 2008 fruit smoothies, muffins and USBs were included in the basket

Microwaves, 35mm camera film and CD singles were removed

Family Expenditure Survey: a representative monthly survey of UK household expenditure used to derive changes in the CPI

Limitations of the consumer price index as a measure of inflation Different population groups experience different rates of inflation

The CPI is an average household and not representative of individual households

The weighting for tobacco or motoring expenses will be irrelevant for non smokers and those without a car

The CPI does not include house prices Mortgage prices will be a high proportion of spend of younger house

buyers Many older home owners will have paid off their mortgages

The CPI may overestimate inflation Price rises may hide improvements in the quality of goods and services Cars and electrical goods may have gone up in price but this is due to

new innovations

Causes of inflation Inflation comes from several

sources It can come directly from the

domestic economy Price strategies of leading food

retailers based on the strength of demand or competitive pressures

A rise in VAT cause firm’s production costs to go up and these being passed onto the consumer

It can come from external sources Increase in price of crude oil or

other imported commodities, foodstuffs and beverages

Changes in exchange ratesA falling pound against the Euro

might cause higher import prices (remember WIDEC?)

Causes of inflation There are 3 main types of inflation

that are caused by different thingsa) Demand pull inflationb) Cost push inflationc) Excess monetary growth

As the name suggests demand pull inflation is caused by an increase demand (AD) Most likely to occur when there

is little spare capacity in the economy

Increase in AD will lead to an increase in prices

When does AD increase? When one or more of the

components increases Draw a diagram illustrating demand

pull

Causes of inflation Cost push inflation occurs as a

result of an increase in the costs of production

Any increase in a firm’s costs pushes the supply curve up

If the cost of an input such as oil that affects the costs of all business in the economy increases the SRAS will shift upwards

Things that cause production costs to go up and force firms to raise their prices to maintain profit margins A rise in costs of imported raw

materials (e.g. by a fall in the value of the country’s currency)

Rising labour costs Higher indirect taxes Wage price spirals

Causes of inflation Cost push and demand pull

together Let’s say house prices rise and

the wealth effect comes into play The economy has little spare

capacity (it is working close to full employment)

Consumption increases aggregate demand increases

capacity causing demand pull inflation (1)

workers will demand higher wages to help them keep their current standard of living

This demand for higher wages will cause cost push inflation (2)

Higher wages may also give households the illusion that they have more money

This will further increase consumption and increase AD (3)

Causes of inflation Excess monetary growth Monetarists (a branch of new classical

economists) believe that inflation is caused by excessive increases in money supply

If there is more money in the economy there will be higher spending

AD will increase Because this is a new classical theory

we draw the LRAS vertical Increasing money supply (quantitative

easing) tends to be a policy of last resort

In the UK the Bank of England has recently (2012) decided on a policy of QE because the low interest rates were not encouraging consumption

They believe it is safe to do this because there is spare capacity in the economy but are watching the outcome carefully

Milton Friedman (1912-2006) was a Monetarist who passionately believed that government intervention always causes more harm than good

Reducing inflation The appropriate policy depends on the cause

of inflation If the cause is the price of oil then this is an

external factor which is out of government’s control

If it is demand pull inflation government can try to dampen demand using deflationary/contractionary fiscal or monetary policy

Evaluation There are often problems with contractionary

policies Increasing taxes, reducing government

spending or putting up interest rates are not popular measures

There are lags with both fiscal and monetary policy of 1 to 2 years

Government spending budgets are developed over a long period of time and may need lengthy legislative procedures to make any changes

Reducing inflation / Evaluation Monetary policy will harm some people in the

economy more than others Anyone that has a loan or mortgage and

businesses that want to invest Any government that is looking to be re-

elected will be reluctant to use these measures

This is one of the reasons that many developed countries have monetary policy managed by their central bank which is an independent body

The UK MPC need to make sure that inflation is kept within +/- 1% of 2.5% otherwise they have to write a letter to the government explaining why

The Fed does not have an official target It is important that people have faith in the

central bank to keep inflation rates stable or they will demand higher wages

Reducing inflation / Evaluation Nowadays monetary policy is

considered to be the most effective way of managing AD in the economy

Interest rates are seen as the best weapon

Fiscal policy is not seen as an effective tool for inflation

Governments have commitments to the public so it is very difficult to cut spending

Plus any cut in G would take a long time to have an effect on price levels.

Supply side policies are used to fix cost push inflation (as long as it is a domestic issue)

It is really difficult to say which bit of inflation is cost push and which bit is demand pull so policy makers tend to use a mix of solutions

Reducing inflation / Evaluation The biggest issue with reducing AD

is the loss of output and hence unemployment

Potentially there is a trade off between inflation and unemployment

If unemployment is lowered AD will increase causing inflation

If inflation is lowered AD will decrease causing unemployment

Responsibility for managing AD might be best left to automatic stabilizers of fiscal policy and careful changes in monetary policy carried out by and independent central bank

HL onlyCalculating Inflation

Using index numbers This is straight forward if you

can calculate percentage changes

This table shows the made up index of house prices

2005 is the base year In 2006 there is an increase of

8.4% so the index goes up to 108.4

In 2007 there is an increase of 20% since 2005 so the index is 120.0

We need to take more care when working out the percentage change from 2006 to 2007

It is not 11.6% It is (120-108.4)/108.4 x 100 =

10.7% (Difference between the two

years divided by the original year)

Year Index

2005 100.0

2006 108.4

2007 120.0

Using index numbers When we bring several indices together in a basket we have to

give each one a weighting The weighting will depend on the proportion of income that is

spent on that good If we take this example on average 40% of income is spent on

housing so it gets a weighting of 0.4 To work out the weighted index you just multiply the index by the

weight Category Index

for year X

Weight Index for year X times weight

Index for year X +1

Weight Index for year (X+1) times weight

Housing 120 0.4 48 130 0.4 52

Foodstuffs 105 0.2 11 105 0.2 11

Travel 120 0.2 24 125 0.2 25

Clothing 120 0.1 12 110 0.1 11

Entertainment 125 0.1 12.5 130 0.1 13

Totals 107.5 1 112

Using index numbers To find out the rate of inflation you need to do the following sum New index – old index divided by old index In this case it would be Index for (X +1) minus Index for X

divided by Index for X Multiply by 100 to get the % inflation rate (112 – 107.5) / 107.5 = 4.2%

Category Index for year X

Weight Index for year X times weight

Index for year X +1

Weight Index for year (X+1) times weight

Housing 120 0.4 48 130 0.4 52

Foodstuffs 105 0.2 11 105 0.2 11

Travel 120 0.2 24 125 0.2 25

Clothing 120 0.1 12 110 0.1 11

Entertainment 125 0.1 12.5 130 0.1 13

Totals 107.5 1 112

Time for you to do some work!!For homework do some research on inflation in your chosen country SL – P241 1a & bHL – P242/3 Data Response

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