IB Economics Ch 19 Inflation and Deflation

Background to Inflation Inflation: a sustained increase in the general price level –CPI (HICP) A weighted index of 14 categories: Family Expenditure Survey The UK official inflation figure Price stability defined as 2% CPI inflation Symmetrical target (compared with asymmetric ECB) –RPI & RPIX Why have these old measures become popular during the recession?

Index numbers Base year =100 –2005: 100 –2006: 105 –2007: 110 –2008: 115 –2009: 121 TASK: Calculate the year on year inflation rates for the example above and comment on your findings.

Latest CPI & RPI figures for the UK

CPI 1989 (pre 2007 estimated) to 2009

RPI

Causes of inflation Internal factors –Changes in sales taxes e.g. VAT –Strength of AD –Pricing strategies by domestic firms External factors (or shocks) –Rising imported raw materials –Inflation in other countries –Strength of other economies Demand pull Cost push Excessive growth of the money supply (see Milton Friedman)

Cost push inflation A rise in costs of imported raw materials –e.g. oil Rising labour costs –e.g. trade unions Higher indirect taxes –How will the increase in VAT in January 2010 affect the UK economy? Wage price spiral –How do expectations affect wage negotiations?

Cost push AS/AD diagram TASK: Complete the diagram

Demand Pull Lack of spare capacity –e.g. factories cannot expand Too much money chasing too few goods –e.g. Increases in pay that are not linked to increased production Consider what happens in an auction –Limited supply, there can only be one winner but at a higher price

Demand Pull TASK: Complete the diagram

Growth in the Money Supply TASK: Complete the diagram

Consequences of inflation –International competitiveness –Effect on investment –Unanticipated inflation –Menu costs –Shoe-leather costs –Effects on distribution of income –Worsening of industrial relations –Fiscal drag –Hyperinflation So if inflation is so bad why do we target inflation to be positive and worry about it being too low?

Deflation A fall in the general BAD Vs GOOD deflation Unemployment The effect on debt levels The effect of delayed spending The effect on investment Recent examples –Japan late 1990’s –India 2009 –UK 2009? If you consider RPI

Source:

How do we reduce inflation and avoid deflation? Monetary Policy –Interest rates –Minimum reserve ration –Quantitative easing Fiscal Policy –Changes in spending –Changes in taxation Supply-Side Policy

Controlling Inflation - FISCAL TASK: Complete the diagram

Controlling Inflation - MONETARY TASK: Complete the diagram

Controlling Inflation - SS TASK: Complete the diagram