Inflation and deflation

• Real interest rate?


  Nominal interest rate - inflation rate
• Purchasing power?


  the amount of goods or services that can be bought with a given amount of money income
• Effect of inflation on interest?

  If inflation is greater than nominal interest, the real interest rate is negative and savings lose value

  If inflation is less than nominal interest, real interest is positice so savings increase in value
• Cost push inflation?


  occur when the increasing costs of production push up the general level of prices- supply shock inflation due to higher costs of production resulting in a leftward shoft of SRAS curve.

  Causes falling GDP/ recession, known as stagflation

  we have little effect over due to OPEC etc
• OPEC?


  Organisation of petroleum exporting countires

  Cartel- a group that act as a monpoly

  They can reduce production to cause an increase in costs
• Wage-price spiral?


  Caused by cost-push inflation as higher prices cause lower real wages so unions demand higher wages raising firms costs further so the inflationary spiral begins.

  A circular process in which wage increases cause price increases in which causes further wage increases, leading to accelerating inflation
• Wage-price spiral impact?


  The spiral will eventually end and the SRAS will settle before GDP=0 as when workers lsot their jobs due to increased wages, GDP will fall and trade unions will lost their power to commsnd higher wages. This eventually stops the SRAS curve from moving upwards
• Keynsian demand pull inflation?

  Exists when aggregate demand exceeds the value of output, near full employment. This excess demand cannot be met in supply so inflation occurs so excess demand pulls up prices
• Policies to deal with cost push inflation?

  Control price increases- influencing the exchange rate (appreciation), limiting wage rises, subsidies

  Supply-side policies- increase productivity

  Do nothing- expect global prices to fall or appreciation
• Policy to deal with demand-pull inflation?

  Deflationary fiscal and monetary policy-causes a trade ff as lower GDP and higher unemployment

  Supply side- increase capacity so excess demand can be met without inflation- rarely used, more preventative as slow

  best to use AD and AS growth together to avoid demand-pull inflation
• Classical demand-pull inflation?


  AD shifts rightwards, moving up the SRAS. output rises and prices rise as they are 'bid up' by consumers

  Ouput can rise above full employment as firms work above capacity (overtime), may offer higher wages (reduce voluntary unemployment)

  Firms costs rise shifting sras left meaning that higher prices cause a fall in demandand the economy moves up the AD curve back to full employment at a higher price

  Only temporary, the previously voluntarily unemployed will leave the workforce again
• Definition of money?


  any object that is generally accepted as payment fir goods and services, and repayments of debt
• Money supply?


  measures the total amount of money in the economy at a particular time. Includes actual notes and coins, and any deposits which can quickly be converted into cash
• Monetarist view?


  An increase in AD simply increases money supply in the economy, leading to ifnlation, NOT real output. Use a classical SRAS, LRAS curve.

  The only way to increase output is to shift the LRAS right with supply side policies.

  increased money supply= increased SRAS, wage price spiral, inflation
• issues of monetarism?


  V changes if there is a change in the way workers are paid eg weekly to monthly payments- money is held for longer so decreases velocity of circulation.

  V changes with money substitues such as credit cards- make one large payment instead so reduces V

  V changes with speculation in financial markets
• Deflation?


  a sustained decrease in the average price level
• Main causes of deflation?


  Demand-side deflation, a decrease in AD (malign/ bad deflation)

  Supply-side deflation- an increase in economic capacity eg tech improvements resulting in lower production costs and prices (benign/good)
• Bad deflation?


  Due to a fall in AD eg a recession (falling GPD, unemployment, reduced living standards)

  Usually when a recession is long lasting

  Caused by a fall in money supply- quantiative tighnting

  Tight monetary policy- higher interest rates

  austerity, pandemic, overvalued exchange rate to maintain the currency
• Why is a decrease in AD usually on disflation?


  Wages are sticky downwards, so workers may resist nominal wage cuts. Firms may also keep prices the same, but reduce costs
• Good inflation?


  due to tech and productivity improvements, allowing higher incomes and AD.

  May lead to decreased production costs and lower prices, whilst increasing output.

  Increases in LRAS are usually accompanied bt higher AD so typically short

  Real balance effect: falling price = increased consumtipn= increased purchasing power
• Problems of deflation?


  Discourages consumer spending, increases real value of debt, increased real interest rate, real wage unemployment, deflation becomes difficult to end- deflationary spiral
• deflationary spiral?


  AD falls, prices on average fall (meaning even if nominal R/I is zero the real R/I is positive), firms cut wages and deflationary expectations set in, the real value of debt rises, saving becomes more attractive, consumers put off spending in expectation of price cuts, AD falls
• Deflationary expectations?


  the belief by economic agents that prices in general are likely to fall the following time period
• benefits of deflation?


  Increased efficiency and lower costs of production causing deflation- lowers the price level and increases RGDP

  improved international competitiveness- rise in exports. Only if there is not a region wide deflation as this reduces the competitive advantage
• reflationary policies?


  Expansionary fiscal and monetary policies. results in a positive multipler effect-rising emand causes an increase in output so more workers are employed, meaning hgiher incomes and consumption- prices are 'bid up' by consumers and increasing costs for firms increase prices
• Liquidity trap?


  occurs when monetary policy becomes ineffective because, despite zer/ very low interest rates, people want to hold cash rather than spend or buy financial assets

  may be due to low confidence in a recession, people paying off debts instead, banks not wantying to lend, banks not passing the full base rate decrease to consumers
• reflationary policies?


  expansionary monetary and fiscal policy

  Helicopter drop, quantitative easing, changing deflationary expectations, devaluation