Inflation and Deflation

How do we define inflation? “A continuing increase in the general price level”. But let’s focus on some key words in the definition

Inflation defined…. Continuing means the increase must be occurring over a period of time, not just a one time increase Increase refers to the rising price level of goods and services on average, not every good and service in the economy General price level is an average of prices of goods and services in the entire economy

How do we define deflation? “A continuing decrease in the general price level”. (the same descriptions apply here as in the definition of inflation)

How are inflation and deflation expressed? As a percentage change of the general price level that has occurred over the course of a year (although shorter time periods are also calculated). Inflation is much more commonly seen than deflation

Changes in the price level vs. changes in rate of inflation Consider this: In one year we have an increase in the general price level of 5%, followed the next year by an increase in the general price level of 7%. What can we say is happening to the price level and inflation rate in both years?

Changes in the price level vs. changes in rate of inflation Now assume we have an increase in the general price level of 10%, followed the next year by an increase in the general price level of 7%. What can we say is happening to the price level? What can we say about the rate of inflation?

Causes of inflation There are three causes of inflation. Can you recall any or all of these?

Demand-pull inflation This type of inflation is caused by increases in AD which move the economy beyond the equilibrium level of real GDP and the equilibrium price level. Demand-pull inflation is associated with an inflationary gap, and the unemployment rate falls below the natural rate of unemployment.

Demand-pull inflation

How to deal with demand-pull inflation? Simple, just reduce AD by enacting contractionary fiscal policy or “tight-money” monetary policy. This should bring the AD curve back to the equilibrium level of real GDP and lower the average price level.

Cost-push inflation This type of inflation is caused by increases in costs of production which move the economy below the equilibrium level of real GDP and above the equilibrium price level. You can also think of this as the negative supply-shock phenomenon as input costs rise and firms supply less output.

Cost-push inflation

How to deal with cost-push inflation? It depends. If increasing wage rates are the root of the problem, the supply-side folks have lots of ideas. If the problem is caused by increasing commodity prices (like oil), efforts to reduce oil consumption could lead to lower prices, as demand for oil falls, but this won’t happen overnight…

More sources of cost-push inflation Monopolies and/or oligopolies may behave in a manner as to increase prices to raise profits. Supply-side policies to dismantle these firms may be in order.

More sources of cost-push inflation A depreciating domestic currency may increase input costs for firms if they use foreign goods in production. Efforts to reduce reliance on imports could solve this problem.

Excessive growth in the money supply Monetarists argue that changes in the money supply affect the general price level. They use the quantity equation on the next slide to express their views…

V= velocity of money (or circulation) Quantity Equation M X V = P X Q Where M = money supply V= velocity of money (or circulation) P = price Q = quantity of output

M X V = P X Q M X V = total spending in the economy P X Q = nominal value of GDP Because total spending and the value of GDP are equal as we learned when discussing the three methods of calculating GDP, the equation is true. Now let’s go further…

M X V = P X Q Monetarists make two assumptions: V is stable over short periods of time Q is determined by quantity and quality of factors of production, not the supply of money or the price level So any change in M will directly affect P

Inflation due to increase in money supply

Inflation due to increase in money supply Monetarists argue that increasing the money supply (M) will shift AD to the right as C and I spending increase. In the short-run, output increases and price level does too, but in the long-run, output returns to the equilibrium level and all we have is a higher price level (P)

Monetarists believe: The long-run happens quickly, so gains in output are short-lived Demand-side policies can’t increase real GDP in the long-run In benchmarks for increasing money supply (GDP grows by 3%, increase the money supply by 3%)

Last word on monetarism The monetarist conclusions are subject to debate. Their conclusions about the relationship b/w money supply and inflation holds in the long-run, but not so much in the short-run One thing is clear, if you want hyperinflation, you must increase the money supply!

Costs of inflation One cost is the loss of purchasing power. If your income remains constant and the general price level rises, your purchasing power has decreased. You can no longer buy the same quantity of goods if the price level is increasing more rapidly than your real income 

Who fits in this category? Costs of inflation Inflation redistributes income from one group to another. If you have a fixed income and the inflation rate begins to rise, you end up with less money than before. Who fits in this category?

Workers with fixed wage contracts Fixed income folks Workers with fixed wage contracts Pensioners Landlords Welfare recipients

Other Inflation losers Holders of cash People who save money People who lend money

Payers of fixed incomes or wages Inflation Winners Borrowers Payers of fixed incomes or wages

Other Inflation Problems Firms get antsy when it is difficult to predict what is happening with the general price level. They may be unwilling to invest in new capital goods if they fear customers may lose purchasing power in the future. This general level of uncertainty may slow economic growth.

Other Inflation Problems Menu costs suggest that firms will incur large printing costs as the general price level fluctuates. Sounds silly, but this can still be a real expense for a firm if they have to constantly redo their pricing lists.

Other Inflation Problems A “money illusion” may fool people into thinking they are doing better than they really are. If you get a 10% raise at work, but the inflation rate is 15%, you are obviously worse off, but if you are not paying close attention to the general price level, you might make some foolish spending decisions

Other Inflation Problems If a country is experiencing inflation, it’s exports become more expensive to foreign nations and imports become cheaper than domestically produced goods. This can severely disrupt a country’s trade position and balance of payments

Hyperinflation Inflation gone wild. If the price level increases by 50% a month, you have hyperinflation. An inflationary spiral results and a massive disruption of economic activity occurs. The barter system may take over and significant social problems often follow

Causes of deflation Deflation is a very rare occurrence for several reasons: Worker’s wages rarely fall, so firms tend to not lower the price of the goods they sell Oligopolies abhor price wars Firms try to avoid menu costs

This is what happened during the Great Depression of the 1930s. Causes of deflation Decreases in AD may eventually lead to a decrease in the general price level. Unfortunately, recession often accompanies this change, as do falling incomes and output, as well as cyclical unemployment. This is what happened during the Great Depression of the 1930s.

Decreasing AD

How to deal with less AD? Obviously expansionary fiscal policy and “easy” monetary policy would be in order to shift the AD curve back to the original position

Increases in AS The “good” deflation may occur when the AS curve shifts to the right, thus lowering the average price level while output increases. Economic expansion, rising incomes and output, increasing employment and economic growth may all occur.

Costs of deflation Redistribution of income (opposite as during inflation) Uncertainty for firms may lead to lack of investment Menu costs again….. A deflationary spiral may result as borrowers are discouraged from taking loans, and spending slows by consumers as they expect prices to continue to fall and AD continues to fall….

A major financial crisis could easily occur. Add it all up…. With deflation, the real value of debt rises, the economy is in recession, incomes are falling and bankruptcies result as borrowers are unable to pay back loans. A major financial crisis could easily occur.