Inflation By the end of this session, you:By the end of this session, you: –Should understand the factors affecting inflation. –Must remember the key terminology associated with inflation. –Must remember the difference between benign inflation and malign inflation. –Could be able to apply Monetarist theory and Keynesian theory to inflation/deflation.

Lower interest ratesLower interest rates Increased number of loans to small businessesIncreased number of loans to small businesses A rise in the cost of imported raw materialsA rise in the cost of imported raw materials Rising labour costsRising labour costs Higher indirect taxes eg fuel dutyHigher indirect taxes eg fuel duty Increased borrowing by the government to fund the NHSIncreased borrowing by the government to fund the NHS Wage-price spiralsWage-price spirals Reduced demand for importsReduced demand for imports Spare capacity in the economySpare capacity in the economy Will the following increase inflationary pressure?

Inflation – Terminology Menu costsMenu costs Shoe-leather costsShoe-leather costs Fiscal dragFiscal drag HyperinflationHyperinflation Money illusionMoney illusion Benign deflationBenign deflation Malign deflationMalign deflation Cheaper costs due to technological advancementsCheaper costs due to technological advancements Unanticipated inflation means wage increases are seen as positive.Unanticipated inflation means wage increases are seen as positive. Time people spend looking for cheaper costs.Time people spend looking for cheaper costs. Deflation due to a structural lack of demand.Deflation due to a structural lack of demand. Administrative costs of changing prices frequently.Administrative costs of changing prices frequently. People pay a higher percentage of their income in tax as inflation rises.People pay a higher percentage of their income in tax as inflation rises. Inflation in excess of 1000% p.a.Inflation in excess of 1000% p.a.

Cheaper costs due to technological advancements Benign deflation Unanticipated inflation means wage increases are seen as positive. Money illusion Time people spend looking for cheaper costs. Shoe-leather costs Deflation due to a structural lack of demand. Malign deflation Administrative costs of changing prices frequently. Menu costs People pay a higher percentage of their income in tax as inflation rises. Fiscal drag Inflation in excess of 1000% p.a. Hyperinflation

Economic Costs of Deflation Holding back on spendingHolding back on spending Lower profit marginsLower profit margins Confidence and savingConfidence and saving Debts increase – why?Debts increase – why? The real cost of borrowing increases – why?The real cost of borrowing increases – why?

Keynesian or Monetarist? Cut interest rates to stimulate ADCut interest rates to stimulate AD Monetise the economy to avoid the liquidity trapMonetise the economy to avoid the liquidity trap Increase government spending to boost ADIncrease government spending to boost AD Lower direct taxesLower direct taxes

Monetary Policy to Reduce the Risk of Deflation Cut interest rates to stimulate demandCut interest rates to stimulate demand –Analysis including diagram Consider 4 components of ADConsider 4 components of AD –Evaluation Why might AD not increase?Why might AD not increase?

Fiscal Policy to Reduce the Risk of Deflation Higher government spending and lower direct taxes to boost ADHigher government spending and lower direct taxes to boost AD –Evaluation – why will this not work?

Monetary Policy to Reduce the Risk of Deflation Cut interest rates to stimulate demandCut interest rates to stimulate demand –Analysis including diagram Consider 4 components of ADConsider 4 components of AD –Evaluation Why might AD not increase?Why might AD not increase?

Monetary Policy to Reduce the Risk of Deflation Evaluation: cut interest rates to stimulate demandEvaluation: cut interest rates to stimulate demand –May save instead –Falling asset prices would increase the demand for cash savings –Limited effect because interest rates cannot fall below zero

Fiscal Policy to Reduce the Risk of Deflation Higher government spending and lower direct taxes to boost ADHigher government spending and lower direct taxes to boost AD –Evaluation – why will this not work?

Fiscal Policy to Reduce the Risk of Deflation Higher government spending and lower direct taxes to boost ADHigher government spending and lower direct taxes to boost AD –Increase in national debt for a short-term boost –Low consumer and business confidence –Inflationary pressure if the economy recovers –Extra income may be used to repay debt rather than boost AD

Inflationary Gap

Closing Gaps KeynesianKeynesian –Increase government expenditure –Decrease government expenditure –Lower taxes –Raise taxes MonetaristMonetarist –Quantitative easing –Reduce the money supply –Reduce interest rates –Increase interest rates

Inflation By the end of this session, you:By the end of this session, you: –Should understand the factors affecting inflation. –Must remember the key terminology associated with inflation. –Must remember the difference between benign inflation and malign inflation. –Could be able to apply Monetarist theory and Keynesian theory to inflation/deflation.