3.
ECONOMICS HL — INFLATION
1. Definition
Inflation is a sustained increase in the general price level of goods and services in an
economy over time.
This means that the purchasing power of money decreases.
For example, if inflation is 5%, the average price level has increased by approximately 5%.
Importantly, inflation does not mean every individual product becomes 5% more expensive.
Some prices may rise faster, some slower, and some may fall.
2. Measuring inflation
Inflation is commonly measured using a Consumer Price Index (CPI).
A representative basket of goods and services is created.
The prices of these goods and services are monitored over time.
The percentage change in the index gives an estimate of inflation.
The basket may include:
● Food
● Housing
● Transport
● Clothing
● Recreation
● Education
● Healthcare
The weights given to different products reflect their importance in household spending.
3. Demand-pull inflation
Demand-pull inflation occurs when aggregate demand increases faster than an
economy's productive capacity.
The basic chain is:
AD ↑ → pressure on resources ↑ → firms raise prices → inflation ↑
Aggregate demand is:
[
AD=C+I+G+(X-M)
]
Therefore, inflationary pressure can result from increases in:
● Consumption
● Investment
● Government spending
● Net exports
Example
Suppose the government significantly increases infrastructure spending.
This increases aggregate demand.
Businesses receive more orders.
They may struggle to increase output quickly because they are already near full capacity.
As a result, they may increase prices.
Workers may also demand higher wages because labour demand increases.
This can further increase costs.
4. Cost-push inflation
Cost-push inflation occurs when the costs of production increase.
Possible causes include:
● Higher wages
● Higher energy prices
● Higher raw material costs
● Increased indirect taxes
● Exchange-rate depreciation
For example, if oil prices rise substantially, transportation becomes more expensive.
This raises firms' costs.
Firms may pass these costs onto consumers through higher prices.
5. Effects of inflation
Consumers
Negative
Purchasing power decreases.
If wages rise by 3% but inflation is 7%, real income falls.
Therefore:
[
Real\ income\ growth \approx Nominal\ wage\ growth - Inflation
]
In this example:
[
3%-7%=-4%
]
Consumers have less purchasing power.
Savers
Inflation reduces the real value of savings.
If a person receives 3% interest but inflation is 6%, the real value of their savings is falling.
Borrowers
Inflation can benefit borrowers because the real value of their debt decreases.
However, this depends on interest rates.
If central banks raise interest rates significantly, borrowing may become more expensive.
Businesses
Inflation can increase:
● Wage costs
● Raw material costs
● Transport costs
● Energy costs
This can reduce profit margins.
However, businesses may benefit if they can raise prices faster than their costs increase.
Exporters
High domestic inflation can reduce international competitiveness.
If domestic prices rise faster than prices in other countries:
Domestic goods become relatively more expensive.
Therefore:
Exports ↓ → X ↓ → AD ↓
This can negatively affect economic growth.
6. Policies to reduce inflation
Monetary policy
The central bank can increase interest rates.
Higher interest rates:
→ borrowing becomes more expensive
→ consumption decreases
→ investment decreases
→ AD decreases
→ inflationary pressure decreases
However, this may also reduce economic growth and increase unemployment.
Fiscal policy
The government could:
● Reduce government spending
● Increase taxes
This reduces aggregate demand.
However, contractionary fiscal policy can cause:
● Lower economic growth
● Higher unemployment
● Lower living standards
Supply-side policies
Governments can increase productive capacity through:
● Education
● Infrastructure
● Training
● Deregulation
● Investment incentives
● Improved technology
If LRAS increases, the economy can produce more without generating as much inflationary
pressure.
7. Evaluation
The most important evaluation question is:
What is causing the inflation?
If inflation is caused by excessive aggregate demand, reducing AD may be appropriate.
But if inflation is caused by an oil-price shock, reducing AD may create unemployment
without directly solving the original supply-side problem.
For example:
Cost-push inflation → contractionary monetary policy → AD ↓ → unemployment ↑
The original oil-price shock still exists.
Therefore, the appropriate policy depends on:
● Cause
● Magnitude
● Duration
● Expectations
● Unemployment
● Economic growth
● Government objectives