Section:b

Topic: 6
In ation
&
De ation

Inflation
It is the persistent increase in the
price levels ofgoods services in an economy
over a period of time inflation rates tend
to devalue the money hence the gout wants
to keep it low
Types ofinflation
1 Mildinflation
when price levels rise by relatively high
rates it is called mild 51 10
2 Gallopinginflation
When
pricelevels rise by a
high rate it
is knows as gallopinginflation lot to 20
3 Hyperinflation
It is an extreme form ofinflation
in which price rise by 100 s and 1000 s
The starts to loose its value and
money
the economy
may collapse
4 Deflation
A persistent fall in generalprice
levels ofgoods services This leads to
rise in the value ofmoney
5 Disinflation
It is asituation where general
prices rise with a decreasing rate
Prices but inflation
The causes ofinflation
1 Demand pull inflation
If there is too much demand relative
to the prices will and it is
demand pull inflation
Initially economy is operating below
full employment increase in A D will
lead to prices as well as real G B P
Prices AS

AD

Y Yo y

Nate Demand pull inflation is linked

with unemployment Due to excess demand
we need more goods to make those we
need more employees This is a trade off
b w demand pull inflation s unemployment

Reasons
for in A D AD I G X M
1 Consumerspending due to excessive income lower

interest more wealth etc

2 Capitalinvestment due to lower interest rates
business optimism better technology
3 Gout spending due to expansionary
fiscal
policy spending on publicgoodse g schools
hospitals etc
may also be due
4 Exports S imports This
to a in the value of domestic
currency

2 Cost Push inflation

It caused by costofproduction
is
Firms want to maintain their
profit
margins therefore they their prices This
maybe due to in the prices
of raw materials
wages indirect taxes importprices
Reasons for rising costs
1 raw materials price
In order to maintain the profit
margins prices Shortage mayalso prices
2 Wages
Trade unions negotiate a higher
wage.or it can also be caused by minimum
wage rate
 3 Indirect taxes
This is added into the price
of the
product So if firms want to maintain
profits they would have to the prices

4 Importprices
If import prices due to a

change in exchange rate the finalprice of

raw materials and it will cause cost
push inflation
Price

0 RealGDP
 3 Money supply inflation
This is caused by growth in the
to monetarist
money supply according
school of thought this can be due to
easier credit e.g loans credit cards
to households firms s gout
More
money supply total spending
hence AD causing inflation

Effects ofInflation
1 Hyperinflation
During the time ofinflation money
starts to loose its value hencepeople start to
loose confidence it is specially in times of
hyperinflation
2 Uneven distribution of income
Workers w bargaining power tend
to gain as their income goes up more than
inflation rate However workers w a power
to bargain Gout can protect them
using index linking state benefits or
by
giving interest on
gout securities
3 Menu cost
Businesses need to change their prices
on menus catalogues vending machines
etc which is costly

4 Consumers
consumers loose since their real
income and lessgoods can be bought
w the same amount
money
5 Shoe leather cost
consumers will spend more time searching
reasonable and in search
for prices of interest
rates

6 Savers
If inflation rate higher than the
is
interest rate savers will loose on their
and will save less This finds in economy
saving
7 Lenders
lenders don't want to lend as the value
ofmoney is be at the time ofrepayment
8 Low income earners
Poorget more affected by inflation
compared to the rich
Poorpeople
usually have a single stream
income where as the rich have multiple
of
9 B 0 P Deficit M deficit
If the country's inflation than is higher
its rivals the exports will be more expensive
and imports will be cheaper This leads to
MT hence a deficit as a result the country's
currency may and it gives rise to
unemployment

10 Employees
Employees demand wages in times of
inflation which the cost Wage Pricespiral
wages Inflation Inflation demandfor more
wages
 Business confidence level
Inflation causes business uncertainty
since investors are unsure about the return
on their investment This to the level of
investment in an
economy
12
Hoarding s Black markets
To profit
from endingpricesproducers
hoard stocks of their commodities
consequently creating artificialscarcity
resulting in formation of black markets

Positive I mpacts
ofInflation
1 Creeping inflation goodis

Creeping inflation maysignalinvestors

that the economy is expanding and there
is
vising demand
2 Borrower's benefit
Thevalue individual debt and gout debt
of
and interestpayment will be in real terms
3 Higher tax Revenue
Inflation mightshift individuals into
ahighertone bracket which will generate
more tax revenue for the hence gout
govt
spending on merit goods

4 Higherprofits firms
for
inflation may lead to profits
for the firms which results in expansion
and helps unemployment s contribute
to economic growth
Measurement of Inflation
It is measured by a change in retail price
index RPI or consumer price index CPI these
record the change in generalpricelevels

CPI
It is a measure
ofthe weightedaverage of the
prices of a representative basket ofgoods and
services There are 8steps to calculate CPI
Step 1 Make Basket
To show changes in generalprice levels
it is impossible to record s calculate the price
change of all thegoods services produced in
the
economy So we use statistical techniques
a basket ofgoods
ofsampling for indication
of changes in generalprice level
This basket contains goodsand services
that an average family uses e g food clothing
etc We take the things used by the
fuel
majority luxuries and items used by a limited group
are not added
 Step 2 chooseBase year
A normal year where there is
economic
no political or economic imbalances should
be taken as the Base Year Base
year is a
standard year with which the restof the
years prices are compared with Price level
in the base
year are represented by 100

Step 3 Price data collection

Statistical dept ofgout collects the info
on base
year prices and current year prices
This price information is collected from retail
outlets newspapers and price lists

Step 4 weight
consumers spend more on some goods then
others so thesegoods should be given more
importance Commodities should be given a
weight which represents their importance in
consumerspending
weight Expenditure on Good 100
Total expenditure
 Step 5 Index
Index calculation
Index current year Price 100
Base
year Price

Step 6 weightedPrice index

Weights are multiplied by the indexes
to calculate weighted indenen
A weighted price index measures the
change in price levels inflation and takes
into account the differentproportions
spent on items in the basket
WeightedPrice index index Weight

step 7 CPI
CPI is obtained by taking sum of
all the weightedindenes and dividing it by
total weights
CP I Total weighted index
Total weights
Step8 Inflation
Inflation is calculated by taking a

age change in current year averageprices

CPI to base CPI
year

Rate ofinflation CPI c CPIB 100

CPIB

No weight Index
1,4
0 I
0.15
takeas it is

IIIEi 0.5
 Difference
RPI CPI

1 RP I includes cost CPIincludes costpaid of a

of housing 1
financialservice only
mortgage interest other
housingcosts 2 Takes into account all the
individuals
2 Itcalculates the avghouseholds
andignores the toorich andthe
verypoor 3 calculatedusinggeometric
mean
3 It is calculatedusing
arithmetic mean

The govtpolicies to cure inflation

1 Contractionary AD
fiscal p olicy
We Govt spending s taxes
Tax I income consumption AD inflation
govt spending ADD Inflation

Adv Disado
1 tax coulddemotivate workers
1 in taxeshas a more quick toput in effortandproductivity
effectin an economycompared
to interestrateschange 2 Thecutscouldtakeawhileto have
2 Cuts in publicexpenditure canhave aneffectandcould
leadtounemployment
amajoreffectgiventhe no of people
andreductioninoutput
employedandthis canhave a knock
oneffecton theeconomy
2 Contractionary monetarypolicy WA D
The gout reduces moneysupply
and increases the interest rates
Moneysupply Peoplehavelessmoney to spend
consumption Inflation b
IRP Borrowingto consumption Inflation

Adv Disadr
1 in IR maybelimited especially
1 IRP costofborrowing inthe shortterm particularly
wheredemandis interestinelastic
meaning it is expensive
to borrow so AD
2 the moneysupplymaytake
2 in moneysupplyreduces a while tohave an effect sbanking
the extentofliquidity in institutesmayfindways to
workaroundtherestrictions
the economymaking it makingeffect v limited
hard to borrow money

3 Supply side policies

S apply side policies increase the
supply and reduce inflation
4 Currency Revaluation
Arise in currencyprice will inflation
MT AD inflation
Deflation
A persistent fall in the general
price level of goods and services in the
economy A ve rate
ofinflation
Increase in A S
AS due to better technology cheaper F O Ps
lower taxes better education etc
AS AS
AD
This type ofdeflation
is non
threatening
p
p

41

Decrease in A D
AD can be in times of recession
and rising levels ofunemployment This
type is as G D PSSOk
type deflation harmful

AS

p
p

AD
AD
Yet

Advantages Disadvantages
1 1 Unemployment
Efficiency Deflationdue ADI lessworkersneededforproduction
to efficiencyand andcost production
of causinglayoffs
The favorabledeflationinvolves prices 2 Bankruptcies
andby productivityandbettertech AS consumerspending lowersalessprofits
shiftsrightwardsleadingto doprices forfirmsshutdown
GDP
3 Debt
2 Improvedinternationalcompetitiveness Therealcostofborrowinggoes
Hacountry whileanotherhasinflation
hasdeflation
thencountryAbecomesmorecompetitiveleading
4 Consumerconfidence
toaf.inexports However ifthereis a Stbasconsumersmaypostponespending
regionwideperiodofdeflationthen to in anticipation evenlowerprices in
of
competitiveedge thefuture
Policies to correct Deflation
1 Expansionaryfiscalpolicy A D
gout spending and Taxes
Tone Income consumption AD Deflation
Govtspending AD Deflation

2 Expansionary monetarypolicy A D
Moneysupply Interest
Moneysupply spendingpower consumption
Deflation
Interest rates 6 Borrowing consumption
Deflation

3 Print money A D
Printing money price according to
quantity theory ofmoney As we should
getinflation A policy for printing money
is termed helicopter drop where central
givesnewly printedmoney to consumers directly
Bankers don't do this as it goes
against their inflation nature
 fighting

But it is an effective measure against

deflation.The problem is to figure out how
much to print

4 Devaluation AD
value of money by sellingdomestic
currency or
money supply to try and
devalue It will help inflation
currency
and inflation expectation through a
boost to domestic exportsand import
prices
My A.PT Deflation
In case ofregionaldeflation manycountries
maybe trying to do the same thingleading
to competitive devaluation It will also
living standards by makingexportsexpensive