1. Inflation
ECO 12/4/3

2. Inflation
Is an increase in the general price level or average price level
This means the price of most goods and services in the economy have risen on average

3. Disinflation A decrease in the rate of inflation.
Note inflation is still occurring just at a lower rate e.g. inflation falls from 5% to 2% , [Price level is still rising, but at a declining rate]
This is like a runner slowing down - they are still going forwards but at a slower speed

4. This is like a runner going backwards
Deflation
Occurs when the general price level FALLS .
i.e. when the change in the general price level is negative
This is like a runner going backwards

5. Consumers Price Index CPI
Inflation is measured using the Consumers Price Index
A rise in the CPI [Consumer Price Index] means inflation has occurred
A rise in the CPI by a lesser amount means disinflation has occurred
A fall in the CPI means deflation has occurred

6. Purchasing Power
How many goods and services you can buy with a set amount of money
Inflation reduces the purchasing power of money
e.g. $100 buys less goods and services now than it did a year
ago due to inflation

7. Individual Price Rise versus a General Price level Rise
Individual price rise – a rise in the price of ONE good or service only
General Price Level rise – a rise in the price of most goods and services
An individual price rise of one good/service rise is not inflation as many other goods may not have changed in price, meaning the average price level won’t change.
However, a rise in the price of some goods such as petrol which is a cost of production for most firms may lead to many other goods and services rising in price.

8. Nominal vs Real Indicators
Nominal – is the money or face value of an indicator
e.g. nominal wage is money value of your wages say $125 per
week
Real – nominal values adjusted for inflation
e.g real wage is the nominal wage adjusted for inflation
If your nominal wage increases by 4% and inflation is 3% then in real terms your real wage has increased by only 1%

9. Quantity Theory of Exchange
M x V = P x Q
M = Money Supply
V = velocity of circulation – how fast money
changes hands to finance transactions
P = Price Level as measured the CPI
Q = Quantity of national output

10. Crude Theory
Assumes that V and Q are unchanged so that increases in M lead directly to increases in P
i.e increases in the money supply lead to inflation.
M V = P Q

11. Sophisticated Theory Assumes that all variables can change
so increases in M lead may actually lead to increases in Q rather than P [the increase in M is soaked up by the increased output]
M V = P Q 
However if the economy is near full employment it is difficult to increase national output [Q] as nearly all resources are fully employed. In this case increases in M will lead to increases in P as Q cannot increase much, if at all.

12. Sophisticated Theory [cont]
A key idea of the sophisticated theory is
An increase in the money supply will only be inflationary [increase P] if the rate of growth of the money supply [M] exceeds the rate of output [Q] in the economy.

13. Aggregate Demand Aggregate Demand
- the quantity of output that will be purchased at a given price level and represents the total demand in the economy.
Price Level
[PL] AD
Real GDP [Y]

14. Factors Affecting Aggregate Demand
Consumption [C]
Investment [I]
Government Spending [G]
Export Receipts [X]
Import Payments [M]

15. direct tax/ income tax
AD C
income
direct tax/ income tax
consumer confidence
interest rates
inflationary expectations/ future prices I
business confidence G
Govt spending decisions X
exchange rate
overseas demand
overseas trade barriers e.g. tariffs
tastes/ preferences M
tastes preferences
NZ trade barriers e.g. tariffs

16. Increase in Aggregate Demand
Price Level
[PL]
AD1 AD
Real GDP [Y]
A decrease in aggregate demand is the opposite.

17. Aggregate Supply
- the quantity of national output firms are willing to supply at each general price level.
Price Level
[PL] AS
Real GDP [Y]

18. Factors Affecting Aggregate Supply
Nominal Wage
Cost of imported raw materials
Productivity
Indirect Taxes
Technology

19. Imported raw materials cost skilled labour leaving NZ
AS
 nominal wages
Imported raw materials cost
exchange rates
overseas price
productivity
technology
skilled labour leaving NZ
Indirect Tax
GST tax
excise tax
Technology

20. Increase in Aggregate Supply
Price Level
[PL] AS AS1
Real GDP [Y]
A decrease in aggregate supply is the opposite.

21. Aggregate Demand and Supply Equilibrium

22. Cost Push and Demand Pull Inflation
Demand Pull Inflation – any factor that increases Aggregate Demand will cause Demand Pull inflation.
Cost Push Inflation – any factor that decreases Aggregate Supply will cause Cost Push inflation

23. Demand Pull Inflation Price Level [PL] AS PL1 PLe AD
Ye Y Real GDP [Y]
Demand pull inflation is shown by the increase in price level from PLe to PL1
AD1

24. Cost Push Inflation Price Level [PL] AS1 AS PL1 PLe AD
Y Ye Real GDP [Y]
Cost Push inflation is shown by the increase in price level from PLe to PL1

25. THE BUSINESS OR TRADE CYCLE
All economies have cycles of economic activity with periods of strong growth [booms] being followed by periods of low growth [recession].
These fluctuations are caused by changes in aggregate [overall] demand in the economy.

26. The Trade or Business Cycle

27. The Trade or Business Cycle
Recession [or Downturn]
a period of lower economic growth
[i.e. falling real GDP or low increases in real GDP]
demand for goods and services is falling
employment is falling, unemployment rising
incomes are not rising as quickly
prices are likely to rising less quickly [disinflation].
The official definition of a recession is real GDP falling for two consecutive quarters.

28. The Trade or Business Cycle
Trough
a period of very low or negative economic growth
demand for goods and services is very low
employment is at low levels, unemployment high
incomes are not rising
prices are unlikely to rise or possibly fall [deflation]
[A severe or extreme trough is called a depression]

29. The Trade or Business Cycle
Recovery
a period of rising economic growth [i.e. rising real GDP]
demand for goods and services is rising
employment starts to rise, unemployment falls
incomes rising
prices start to rise [called inflation].

30. The Trade or Business Cycle
Boom
a period of high economic growth [i.e significant increases in real GDP]
demand for goods and services is very high
employment is near or at its maximum, unemployment is very low
prices may also be rising rapidly as extra demand for output encourages firms to raise their prices. [higher inflation]

31. Impacts of Inflation on Households
Savings: LOSE
Inflation creates a disincentive to save, people are more likely to spend money now before prices increases
Inflation erodes the real value of savings i.e. your savings buy less goods and services than they did before.
[Note: interest rates compensate for this but your real return is still reduced e.g. if interest rate on savings is 6% then your savings are increasing in value by 6% but if inflation is 4% then your savings are decreasing in value by 4%. Overall your real return is 2%]

32. Impacts of Inflation on Households
Borrowers: WIN
Inflation creates an incentive to borrow as borrowers pay back less in real terms i.e. the dollars which are repaid buy less goods and services than before .
As assets increase in price during times of inflation people can borrow more against the asset i.e. if banks let you borrow 80% of the value of your home then if the value of your home increases then you can borrow more money.

33. Impacts of Inflation on Households
Borrowers: WIN [continued]
Leverage - the amount borrowed as a percentage of the value of an asset falls if the asset increases in price/value due to inflation
e.g. buy a house for $ and borrow $ to finance it [ loan = 80% of the house value]. Over the next 5 years The value of the house rises to $ due to inflation. The original amount of the loan is now only 66.67% of the house value

34. Impacts of Inflation on Households
Fiscal Drag: LOSE
As people’s income tend to increase during inflation they move into a higher marginal income tax bracket.
Planning/Budgeting: LOSE
More difficult to budget for day to day living expenses or plan ahead to buy assets such as houses because it is more difficult to know what prices will be in the future.

35. Impacts of Inflation on Households
Fixed Income Earners: LOSE
Their income falls in real terms i.e their income stays the same as prices rise so their income buys less.
This especially affects those people on benefits such as the unemployment benefit or superannuation.
Incomes that rise faster than inflation: WIN
Those people who get paid commission based on the value of what they sell may find their income increases as prices/values increase. Also people whose skills are in high demand or who are members of strong unions may be able to demand larger pay increases.

36. Impacts of Inflation on Households
Holders of Real Wealth: WIN
The value of assets such as houses tends to keep pace or rise more than the inflation rate.

37. Impacts of Inflation on Firms
Factor Costs: LOSE
Inflation forces up firm’s production costs. This may reduce profit especially if the firm is in a competitive market where they may lose sales if they increase prices [to compensate for increased costs.]

38. Impacts of Inflation on Firms
Investment LOSE
Inflation causes prices of factories, machinery and vehicles etc. to rise so it is more expensive for firms to expand.
Inflation causes business confidence to fall and discourages investment as higher returns are needed to compensate for inflation and so investment is
seen as a
higher risk.

39. Impacts of Inflation on Firms
Planning: LOSE
Makes planning more difficult as future costs and prices are harder to predict if they are increasing.
Financing/Borrowing: WIN
similar to households
Inflation encourages debt as the amount you have to pay back falls in real terms
Can borrow more against value of firm’s assets
Leverage – loans as a percentage of assets falls.

40. Impacts of Inflation on Firms
Speculation:
Businesses are more likely to speculate on non productive assets that are likely to increase in price quickly during times of inflation e.g. buying sections of land
Inflated Results: LOSE
Business revenue and profits may rise simply because firms have increased their prices. This may mislead businesses into that they are performing better when in actual fact their “real sales” are the same or worse.

41. Impacts of Inflation on Firms
Exporters: LOSE
If NZ’s inflation rate is higher than other countries we trade with then the cost of producing goods in NZ rises more than the cost of producing overseas. Exporters can either increase prices which means NZ exports are less price competitive overseas leading to less sales or they may decide to leave overseas price unchanged and take a cut in profits in order to remain competitive.

42. Impacts of Inflation on Firms
Importers: WIN
Imports become more price competitive. If NZ’s inflation rate is higher than other countries we trade with then the price of imported goods rises less than the price of NZ goods so they become more price competitive.

43. Impact of Inflation on Government
Government Spending e.g.
Rising costs/prices means Govt. will have to spend more on health, education, police etc.
Beneficiaries may demand benefit increases to offset the the fall in real income/purchasing power.
Government Income e.g.
Increased spending due to higher prices/inflationary expectations will increase GST revenue.
Rising incomes will mean more people in higher income tax brackets so more income tax revenue.

44. Impact of Inflation on Government
Operating Balance
Increased Government spending has a negative effect on the operating balance
Increased tax take through GST and income tax will have a positive effect on the Government operating balance
Overall effect of inflation on the operating balance depends if the positive effect of increased tax is greater or less than the negative effect of increased spending.