Inflation/Deflation

Inflation ~Inflation is defined as a persistent increase in general price level. Deflation ~Deflation is defined as a persistent decrease in general price level.

Remark: -Once and for all increase in price level is not inflation.Only a persistent increase in price is inflation.

Measurement of inflation (1). Consumer Price Index (CPI) -to measure the price changes of consumer goods (including consumer service). -CPI’s in Hong Kong 1. CPI A 2. CPI B 3. CPI C (formerly known as Hang Seng CPI) 4. Composite CPI

-Reflect the effect of price changes on the lower expenditure group, the middle expenditure group and the higher expenditure group and the household sector as a whole respectively. -Different weights of different expenditure groups on different items are assigned. - If the CPI increase, it means ~cost of living ~the living standard ?

(2). Implicit GDP Deflator = GDP at current market price. GDP at constant market price × 100% Question: The GDP at current market prices of Country A was $ in 2001 and the GDP at constant market price was $ Find the implicit GDP deflator of Country A in Answer: 150

Difference between the CPIs and GDP Deflator -The CPIs reflect the changes in prices of consumer goods (goods and services ) only but the implicit GNP deflator is a price index which reflects changes in prices of all goods and services (including consumer goods and capital goods) in the GDP.

Inflation Rate ~Inflation rate is the percentage change in the price index with respect to last period.

Calculation of Inflation Rate (A) Using consumer price index (CPI) Inflation rate: = CPI in the current year – CPI in the last year. CPI in the last year (B) Using implicit GDP deflator Inflation rate: = GDP in the current year – GDP in the last year. GDP in the last year × 100%

Question : Find inflation rate : - CPI/Implicit GDP deflator in 1999=120 - CPI/Implicit GDP deflator in 2000=150 Answer : × 100% =25%

Economic Effect of Inflation (1). Purchasing power of money = Real value of money = money in real term

Question : -‘When the inflation rate is decreasing, there is no inflation.’Do you agree? Answer : -If the inflation rate is still positive such as decreasing from 5% to 3%, there is still inflation. That means the price index still increase by 3% compared with the last year.

~ If inflation exists, the purchasing power of money will decrease. Difference between real value of money and nominal value of money. ~ If inflation exists, the real value of money will The nominal value of money will remain unchanged.

(2). Cost of living -Cost of living means the money amount needed to buy the amount of goods and services for people’s basic needs. - If inflation exists - the cost of living will -the living standard will decrease, increase or remains unchanged.

(3). Real income / standard of living Case 1: -If the inflation rate > the % increase in nominal income The real income / the living standard will decrease. Case 2: -If the inflation rate < the % increase in nominal income The real income / the living standard will increase.

Case 3: -If the inflation rate = the % increase in nominal income The real income / the living standard will remain unchanged.

(4). Balance of trade = Exports of goods – Imports of goods = visible trade balance -If the inflation exists, the price of exported goods will increase. The volume of export will decrease. -The price of imported goods is relatively cheaper. The demand for imported goods will decrease. -There are less exports and more imports. Inflation causes an unfavourable effect on the balance of trade.

(5). Choice of wealth -When there is inflation, people will prefer to hold physical assets, such as shares shares, houses and gold, rather than the money or saving because the real value of money will decrease. (6). Effects on Tax Payment -When there is inflation, the money wage will increase. -One’s income may exceed the tax allowance or fall into a higher tax bracket.He has to pay more salaries tax.

(7). Redistribution of income -Inflation helps to redistribution income from one group to another group.

People who gain are: -Employers gain because they pay their employees an amount of money wages according to their employment contract. So they pay less in real terms. -Bankers gain because the real value of their deposits and interest payment decrease. -Debtors gain because the real value of their debts repayment and interest payment will decrease.

-Insurance company gain because the real value of the insurance payment will decrease. -The government will gain because the tax revenue will increase because the money wage of the the workers will increase. So their income may exceed the tax allowance or fall into the higher tax bracket.

People who lose are: -Employees, especially the fixed income earners, loss because their real income will decrease as the inflation rate is greater than the percentage increase in money income. -Depositors lose because their saving and interest are worth less in real terms. -Creditors lose because they will receive less in real terms than what they lend to the debtors.

-Insurance policy holders lose because the amount of money they can receive will be reduced in real term. -The tax payers lose because their money wage increase. So their income may exceed the tax allowance or fall into the higher tax rate bracket. So they pay more tax.

1.When both the price level and the money income level of a society rise, A.The living standard will drop because the value of money decrease. B. The living standard will rise because the citizens have more money to spend. C. The living standard will not change because the rise in income is offset by the rise in price. D. The effect on the living standard is not certain because the extent of both changes is unknown.

2. During inflation, the _______ of the people increase(s) and more people are out into the tax net or into higher tax brackets. Given the same tax allowances, their_______ actually increase(s). A. Nominal income, tax burden B. Real incomes, nominal incomes C. Nominal incomes, real incomes D. Tax burden, nominal incomes

3. In Hong Kong, inflation at the consumer level has remained at around 10% for the past few years. Which of the following are two possible reasons for this phenomenon? 1. A recession affecting western economies 2. The surplus budgetary policy of the government 3. low interest rates for bank deposits and loans 4. An inflow of capital from China A. (1) and (2) onlyB. (1) and (4) only C. (2) and (3) only D. (3) and (4) only

4. Under which of the following circumstances will the per capita real GNP understate the living standard? A. When the construction industry causes noise pollution. B. When there is an increase in pollution due to immigration C. When Mrs Lam does the housework by herself instead of employing a servant D. When there is inflation

5. Who will lose during an unanticipated inflation? A. Mrs Lee, who has hired a Filipion maid B. Mr Chan, who has bought ten coupons which can be exchanged for cakes at a bakery. C. Mr Fu, who runs a restaurant D. Mr Wong, who has put all his money in his time deposit account

Yuen Ting Chi 5A(40) Kwok Ching Nga 5B(18)