●●●●●●●●●●●●●●●●●●●●●●●●●●

10 Revision – Inflation and deflation

Inflation: A sustained rise in the general level of prices (usually retail prices)
and a fall in the value of money. Note that this is not a fall in the exchange
rate; it is the purchasing power of money that has fallen.
Inflation rate: It is usually measured by governments using a retail price
index (RPI). The rate of inflation is the percentage increase in that index over
the previous 12 months.
Inflation measures: Inflation is sometimes measured using other prices, such
as commodity prices, food prices, house prices, import prices, and so on.
Deflation: A sustained fall in the general level of prices (usually retail prices)
and a rise in the value of money.
Demand-pull inflation: Occurs as a result of increasing aggregate demand
(AD) in the economy.
Cost-push inflation: Occurs as a result of an increase in the costs
of production in an economy, leading to a fall in short-run aggregate
supply (SRAS).
Supply-side policies: Policies designed to shift the long-run aggregate supply
(LRAS) curve to the right. There are two types, interventionist policies and
market-oriented policies. The main weakness of supply-side policies is that
they take time to have effect. The main weakness of interventionist policies
is that they are expensive. The main weakness of market-oriented policies is
that they create greater income inequality.
Demand-side policies: Policies designed to shift the AD curve in order to
expand or contract economic activity. There are two types, fiscal policies, which
alter the levels of direct taxation and government expenditure, and monetary
policies, which alter the levels of interest rates and money supply.

Why do we worry about inflation and deflation?

Consequences or costs of inflation
l It harms those on fixed incomes or those who do not have
bargaining power and so their pay rises do not keep up with
the inflation rate.
l It harms those who save and benefits those who borrow.
l It redistributes wealth to those with assets, e.g. property, that
rise in value particularly rapidly during periods of inflation.
l It causes uncertainty among the business community and so
there is a tendency not to invest.
l It tends to worsen the balance of payments. Export prices
become relatively more expensive and imports become
relatively cheaper. The outcome depends upon the price
elasticity of demand (PED) for exports and imports.
l Interest rates tend to be forced up so that the ‘real’ rate
remains positive.
l Resources are wasted in coping with the effects of inflation,
e.g. constant re-pricing, accountants and other financial
experts having to be employed by companies in order to cope
with the uncertainties.
l Conflict is often caused when pay negotiation takes place.

1
© OUP: this may be reproduced for class use solely for the purchaser’s institute
 Revision ● Inflation and deflation

Consequences or costs of deflation

l It leads to deferred spending by consumers and firms.
l It leads to low investment by firms, which then has
implications for economic growth.
l It benefits lenders and harms borrowers.
l It may well improve the balance of payments, depending upon
the price elasticity of demand for exports and imports.
l Interest rates tend to be very low.
l It redistributes wealth from those with assets to those who are
earning high incomes or who have high cash balances.

What causes inflation and deflation?

Demand-pull inflation

Average price level

This is when inflation originates from rightward shifts in aggregate
demand (AD). As we can see above, if AD rises, firms will respond
partly by raising prices and partly by raising output. Just how SRAS1
much prices rise will depend upon the slope of the short-run
aggregate supply (SRAS) curve. AD shifts from AD1 to AD2. Prices P2
P1
rise from P1 to P2, and output rises from Q1 to Q2. The steeper the
AD2
SRAS curve, the more prices will rise and the less output will
increase. The SRAS curve will tend to be steeper as the economy AD1
approaches the peak of the trade cycle, i.e. as actual output gets
0 Y1 Y2
closer to potential output.
Real output (Y)
Demand-pull inflation tends to be associated with a booming
economy. Thus, it is a counterpart of demand-deficient
unemployment. When the economy is in recession, demand-
deficient unemployment will be high, but demand-pull inflation
will be low. When the economy is in boom, the opposite is to
be found.

What causes inflation and deflation?

Cost-push inflation
This is when inflation originates from leftward shifts in aggregate
Average price level

SRAS2
supply (AS). It is also known as supply-side inflation.
If firms face a rise in costs, they will respond partly by raising SRAS1
prices and passing the costs on to consumers, and partly by cutting P2
back on production. This is shown in the diagram above. SRAS P1
shifts from SRAS1 to SRAS2. Prices rise from P1 to P2 and output
falls from Q1 to Q2. The less elastic (steeper) the AD curve, the
more prices will rise and the less output will decrease. Producers AD
are able to pass on more of the cost increases. With demand-pull
inflation, output and hence employment tend to rise. With cost- 0 Y2 Y1
push inflation, output and hence employment tend to fall.
Real output (Y)
The rises in costs may have different origins. The origins enable us
to differentiate different types of cost-push inflation.
l Wage-push inflation is where trade unions push wages up,
independently of the demand for labour.
l Import-price-push inflation is where import prices rise
independently of the level of AD, e.g. the oil price rises
of 2007.

2
© OUP: this may be reproduced for class use solely for the purchaser’s institute
 Revision ● Inflation and deflation

l Tax-push inflation is where increased taxation adds to the cost

of living, e.g. when VAT was raised from 15% to 17.5%.
l The exhaustion of natural resources is where major natural
resources become depleted and so their prices rise and the AS
curve shifts to the left, e.g. with the gradual running down of
North Sea oil production for the UK or with sea pollution and
thus falls in fishing stocks.
Causes of deflation
There are two types (causes) of deflation.
1. ‘Good‘ deflation is productivity-driven and comes about as
costs and prices are pushed lower by improvements in
productivity.
2. ‘Bad‘ deflation reflects a sharp slump in demand, excess
capacity and a shrinking money supply (as in the USA in
the 1930s).

How do we cure inflation and deflation?

Demand-pull inflation
The appropriate policy is to reduce AD. Thus, the government
could use deflationary fiscal policy (increase direct taxes and
reduce government spending) and/or deflationary monetary policy
(raise interest rates and reduce the money supply).

Cost-push inflation
Deflationary demand-side policies may be used, but they will
result in lower national output and are likely to cause
unemployment to rise. Thus, demand-side policies are ineffective
and supply-side policies are appropriate. However, when inflation
does occur, it is difficult to distinguish between the demand-pull
and cost-push factors, and so policy makers are likely to use a
mixture of solutions.

Deflation
This only really applies if the deflation is ‘bad’ deflation, and then
there is a need for demand-side policies, as described above, to
shift the AD curve to the right, thus reducing the downward
pressure on prices. Although this will expand the economy and
improve employment, it may also lead to inflation, if the process
goes too far.

3
© OUP: this may be reproduced for class use solely for the purchaser’s institute