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Inflation & DeflationInflation & Deflation
Recap & move forward…Recap & move forward…
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RecapRecap
• What was the more recent ‘FIVE’ causes of UK’s rise in inflation last month?
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RecapRecap
• What was the more recent ‘FIVE’ causes of UK’s rise in inflation last month?
• F= Fuel• I = Imports create higher costs• V = VAT• E= exchange rates
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RecapRecap
• In theory – what are the 2 different types of inflation?
–Demand pull inflation–Cost push inflation
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RecapRecap
• Can you draw me a demand pull inflation diagram (show SR & LR AS)
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DEMAND PULL INFLATIONDEMAND PULL INFLATIONPrice Level
Real National Output
Y1
LRAS
Y2
AD1
0
AD
SRAS
In the LR, workers are not willing to sacrifice Leisure
time for more overtime…. But still have high
wage expectations….
demand pull inflation
SRAS2
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RecapRecap
• Can you draw me a cost push inflation diagram (show SR & LR AS)
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Draw an Classical AD/AS Draw an Classical AD/AS diagramdiagram
Price Level
Real National Output
Y1
LRAS
0
AD
SRAS1
SRAS2
Y2
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DeflationDeflation
Is it good or bad?Is it good or bad?
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DeflationDeflation
• Deflation is a sustained fall in the general price level
• A sustained period of negative inflation
• The internal value of money rises
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Deflation for some productsDeflation for some products
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Describe the changes in the data provided.
What effects do you think this had on the
economy?
What’s the trend?
What’s the start &
end points?
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The diagramsThe diagrams
– – demand side cause of deflationdemand side cause of deflation
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DEMAND PULL Deflation…DEMAND PULL Deflation…Price Level
Real National Output
Y1
LRAS
Y2
AD1
0
AD
SRAS
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Demand side causes of DeflationDemand side causes of Deflation
• A Large (adverse) Fall in AD• Exogenous shocks to the economy• A global recession leading to a fall in exports
and investment• A rise in the exchange rate (leading to lower exports and
cheaper imports)• Declines in domestic and international asset prices
– Deliberate attempts by macroeconomic policy to reduce AD through tightening of fiscal and/or monetary policy
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Multi choice…Multi choice…
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Demand-pull inflation is most likely Demand-pull inflation is most likely to be caused byto be caused by
• A total spending exceeding productive capacity.
• B an increase in output.• C a rise in raw material prices.• D a rise in interest rates.
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An economy is most likely to be in the An economy is most likely to be in the boom phase of the trade cycle when boom phase of the trade cycle when
there is a rise inthere is a rise in
• A business pessimism.• B the savings ratio.• C spare capacity.• D the demand for imports.
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Real incomes rise wheneverReal incomes rise whenever
• A nominal incomes rise.• B the price level rises by more than
nominal incomes.• C nominal incomes rise by more than the
price level.• D the rate of inflation slows down.
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Inflation articleInflation article
• Read
• use highlighters to select key positive & negative issues
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What’s so BAD about inflation?What’s so BAD about inflation?
• “RPI is an aggregate figure” – what does this mean?
• Why are interest rates on mortgages such an important monetary tool to control inflation?
• What is the difference between nominal and real prices?
• The article identifies 4 problems of inflation. What are they?
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The diagramsThe diagrams
– – supply side cause of deflationsupply side cause of deflation
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SR Cost ‘push’ deflationSR Cost ‘push’ deflationPrice Level
Real National Output
Y1
LRAS
0
AD
SRAS1
SRAS2
Y2
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LR Cost ‘push’ deflationLR Cost ‘push’ deflationPrice Level
Real National Output
Y1
LRAS
0
AD
SRAS1
Y2
LRAS
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Supply side causes of deflationSupply side causes of deflation
• An Increase in Long Run Aggregate Supply• The supply potential of the economy has been boosted
by a series of beneficial shocks such as
• Impact of rapid technological advances• Reductions in the international prices of commodities and capital
goods• Higher productivity which drives down unit cost of production
– Exploitation of economies of scale leading to lower LRAC• Excess supply in some industries due to over-investment in new
capital machinery i.e. deflation results from a persistent demand deficit over existing and potential productive capacity.
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Deflation – good and bad points!Deflation – good and bad points!
Impact on
Households?Consumers?
Employees? Businesse
s?
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Consequences of DeflationConsequences of Deflation• Holding back on spending: • Consumers may opt to postpone demand if they expect prices to fall further
in the future
• Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on confidence– Mortgage payers on fixed mortgage interest rates will see the real cost of
servicing their debt increase
• The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices
• Lower profit margins: This can lead to higher unemployment as firms seek to reduce their costs.
• Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence –leading to further declines in AD. Higher savings can lead to the paradox of thrift
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Past paper practicePast paper practice
I would suspect that your exam I would suspect that your exam paper will be about recessionary paper will be about recessionary
issues – one being Deflation!issues – one being Deflation!
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QUESTIONSQUESTIONS
1. Explain what is meant by the term “deflation”. (4 marks)
2. With reference to Extract 1, explain the effect on GDP of the change in asset prices in 1990. (8 marks)
3. Explain why “deflation needn’t be all bad”? (line 28, extract 2) (8 marks)
4. With reference to the extracts, examine the problems associated with a long period of deflation. (12 marks)
5. Assess the relative effectiveness of using monetary and fiscal policy to move the economy out of a period of deflation. (12 marks)
6. How might the continuing deflation in Japan affect the global economy? (6 marks)
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Or….Or….
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January 2006 - inflationJanuary 2006 - inflation
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The questionsThe questions