Inflation

• General Price Level 


  An average of all prices in the economy, usually measured by an index
• General or Persistant Price Rise 


  An increase in the average of all prices in the economy measured by an index, such as the consumer price index (CPI)
• Individual Price Rise


  An increase in the price, in a single market

  e.g - the price of bananas increase

  This is NOT inflation
• Inflation 


  A sustained increase in the general price level
• Purchasing Power 


  The amount of goods your income will buy

  Inflation reduces the purchasing power of money (you cannot buy as much for the same amount in dollars)
• Deflation 


  A fall in the general price level
• Nominal Wages


  A Nominal Wage is the value in current year dollars

  e.g - I get paid $1000 a day
• Real Value 


  A Real Value is the nominal value adjusted for inflation

  e.g - my income of $1000 is able to buy less if the prices are rising by 5% so my wages adjusted would only by $950
• Disinflation 


  A slowing in the rate of increase in the general price level, a fall in the rate of inflation
• Hyper Inflation 


  Hyper Inflation is where there is an extremely high rate of inflation
• price stability


  goal of the government to avoid long periods of inflation or deflation to keep prices stable so that money can maintain its purchasing power over time
• Desirable Inflation 


  In an economy, some inflation is desirable. In New Zealand, the governor of the reserve bank is charged with keeping inflation between 1% and 3%
• A large increase in the rate of inflation


  Effects on groups
• Real income of low income households/those on fixed incomes

  Falls as their incomes fail to keep up with the increase in the general price level, so their purchasing power falls and they can buy less than previously
• High rates of inflation

  Can harm exporters because their goods and services are less price competitive, therefore more difficult to sell
• High rates of inflation


  Can benefit importers because their goods and services are relatively more price competitive than those produced by local firms
• High rates of inflation


  Firms may struggle and close down with a resulting increase in unemployment
• As export receipts fall and import payments increase


  The balance of payments current account will deteriorate, creating a greater deficit or smaller surplus
• Deflation - Decrease in the general price level

  Can be viewed as undesirable because it may be a sign that the economy is heading towards a recession. In times of deflation, consumption spending may decrease because households delay spending in the hope that prices will fall further. As consumption spending falls, firms stock levels build up and they cut back production. Part of cutting back production will result in fewer workers needed leading to an increase in unemployment
• Consumer Price Index (CPI)

  Measures changes to the prices of the consumer items New Zealand households buy, and provides a measure of household inflation. Changes in the general (average) price level is measured by changes in the consumer price index. An increase in the CPI will indicate an increase in the general price level, inflation. A decrease in the CPI will indicate an decrease in the general price level, deflation.
• Disinflation 


  Situation where there is a rise in the general price level but by a smaller percentage than the previous time period. Disinflation is a fall in the rate of inflation
• Interest rates 


  The reward for saving or the cost of borrowing. Interest rates are influenced by changes in monetary policy. A tool that a Central Bank can use to carry out monetary policy is the Official Cash Rate (OCR)

  The OCR is the overnight interest rate target that a Central Bank can use to control the price of money
• Changes in Interest rates

  Impact the level of savings, consumption spending, investment, and the exchange rate and therefore on the level of inflation, growth, and employment in an economy
• Fall in interest rates

  Economic activity in an economy is below potential, and there are signs that this activity may fall further with prices falling and the possibility of deflation taking place
• Interest rates decrease


  Consumption spending by households increases because the cost of credit has decreased, households will get a loan to buy items they desire
• Interest rates decrease


  Households will have less incentive to save because they are receiving a lower return on funds put aside for future use
• Interest rates decrease


  Investment spending by firms will increase because the cost of borrowing is lower, meaning the risk of new ventures will be lower, and the returns more profitable
• Increase in consumption spending and investment spending

  Aggregate Demand (AD) increases
• Increase in Aggregate Demand

  Increases economic activity
• Falling interest rates


  Should stimulate economic activity
• Falling interest rates may not always have a stimulatory effect
• If households are concerned about the future and want to reduce debt


  Lower interest rates may not have such a stimulatory effect
• If households decide to save more and spend less

  Lower interest rates may not have such a stimulatory effect
• Many households may have borrowed on fixed interest rates so the fall in interest rates will have no effect on their loan/mortgage expenses until the term expires, meaning there is no change in their consumption spending
• Lower interest rates


  Should increase investment spending
• Business confidence increases as the cost of borrowing has fallen


  Reducing the risks involved, making new ventures more profitable
• If household consumption expenditure is falling or flat, this will mean businesses are less confident to invest despite lower interest rates
• Changes in consumer or producer responses

  Changes in consumer or producer responses due to an increase or decrease in the OCR may not be as expected because there is a 'time lag' - a delay of time between the announcement of a change to the OCR and the interest rates that apply to households and firms. Sometimes, it takes time for banks to pass on cuts in interest rates to their customers. Also, firms may invest more despite an increase in interest rates because they are confident about the future and view the venture they are undertaking as profitable
• Price Increase 


  Market forces of demand and supply will determine the price for a good or service. Price will be determined by the resources used to produce a product, the products relative scarcity, and demand for the product. An individual price rise occurs due to either a shortage in the market, an increase in demand, or a decrease in supply
• Market for a product: shortage

  A shortage (excess demand) will occur in the market where at the existing price, the quantity demanded by consumers is greater than the quantity supplied by producers. In this situation market forces will see the price rise to the equilibrium