Inflation & Deflation

Aggregate=all together Aggregate demand and aggregate supply considers the entire quantity of goods and services in an economy. The equilibrium price in aggregate supply and demand curves is called the price level. P Q S1 D1

Inflation / Deflation What is it? an increase in the price level a decrease in price level How is it determined? by comparing the CPI in different years and noting the change CPI is higher=inflation CPI is lower=deflation CPI= Consumer Price Index

Last year’s CPI (based on 1984 prices ) $ This year’s CPI $ Inflation rate 1.17% Present Year-Past Year _____________________ x 100 Past Year Past Year

Can be caused by supply-side shifts or demand-side shifts Under what conditions would you expect to see inflation (rise in price level)? Under what conditions would you expect to see deflation (fall in price level)? Inflation can be caused by an increase in aggregate demand woohoo!! more people!! more money!! Inflation can be caused by a decrease in aggregate supply oil grain Deflation can be caused by a decrease in aggregate demand Deflation can be caused by an increase in aggregate supply

Simple Quantity Theory of Money If velocity and quantity of output (supply) are constant, more money in circulation leads to higher prices. What does velocity mean? velocity=the average number of times per year a dollar is spent to buy final goods

Simple Quantity Theory of Money If velocity and quantity of output (supply) are constant, more money in circulation leads to higher prices. M x V = P x Q M = money supply V = velocity P = price level Q = quantity of output % change M = % change P

Low levels of unemployment are frequently periods of higher inflation More working people with more money (increase in aggregate demand)

Monetary Policy? remember Monetary Policy? The goal is to maintain price stability and low unemployment.

Monetary Policy Fed is responsible for maintaining price stability and employment “Expansionary Monetary Policy” –goal is to increase money supply to reduce unemployment to avoid deflation “Contractionary Monetary Policy” –goal is to decrease the money supply to reduce inflation

So What? Negative Effects of Inflation –hurts people on fixed incomes (the retired) –hurts savers –hurts lenders (helps debtors) –hurts people who contract to be paid in the future –makes financial decision making more difficult hedging = avoiding or lessening a loss by taking a counterbalancing action. –buy gold or some other store of value besides money

So What? Negative Effects of Deflation –Great Depression! –uneven fall in prices business failures job loss –hurts debtors –hurts property-owners

Stagflation stagnant (persistently high) unemployment and inflation What’s up with that?