5.
2 Inflation – Essay
Frequently asked topics
Distinguish causes of inflation
(i) demand-pull (reduction of interest rate, exchange rate, etc.)
(ii) cost-push (increase in price of raw materials, wages, etc.)
(iii) government action (print money)
Discuss whether an increase in AD will always cause inflation (AS will also increase,
depends on level of output)
Explain the construction of CPI (use of weights on selected products) and discuss its
limitations (new goods, difference in spending pattern, etc.)
Discuss consequence of inflation
(i) internal vs external
(ii) winners vs losers
(iii) low and stable vs high
Discuss consequence of deflation
Essay lists
19S3 Explain the difference between the causes of cost-push inflation and
demand-pull inflation. [8]
17S1 Explain how a fall in an economy's foreign exchange rate can cause both
cost-push and demand-pull inflation. [8]
17W1 Discuss the causes of an increase in aggregate demand. Assess whether such
an increase will always cause inflation. Use diagrams to support your answer. [12]
10W1 Discuss the methods and problems involved in constructing an accurate
measure of the rate of inflation. [12]
19S3 Discuss the most serious problems faced by an economy with a high and
increasing rate of inflation. [12]
15S3 Discuss the impact of a high rate of inflation on the consumers and producers
in an economy and assess whether consumers or producers would suffer more. [12]
10W3 Explain why a low and stable rate of inflation may be beneficial to an economy.
[8]
19W1 Discuss whether deflation is more of a problem in an economy than inflation.
[12]
19S3 Explain the difference between the causes of cost-push inflation and
demand-pull inflation. [8]
Plan
P1 Define AD, AS and inflation
P2 Explain demand-pull inflation
P3 Explain cost-push inflation
Sample
Aggregate demand (AD) is the total spending on an economy’s goods and services at
a given price level in a given time period. It has 4 components: consumption,
investment, government spending and net export. AD=C+I+G+(X-M). On the other
hand, aggregate supply (AS) is the total supply in the economy. It is the total amount
of goods and services that firms are willing and able to sell at a given price level in an
economy. Inflation is the sustained rise in price level over a period of time. There are
two types of inflation: demand-pull inflation and cost-push inflation.
Demand-pull inflation occurs when there is an increase in aggregate demand which
is not matched by an increase in aggregate supply. This is likely to be the case when
an economy is at a situation of full employment. According to monetarists, inflation
is caused by an increase in money supply. Increase in money supply will reduce
interest rate. As a result, the return of saving money decreases, consumer may not
save money in the bank and increase consumption. Meanwhile, it is cheaper to
borrow money from the bank; consumer may purchase cars or houses as the cost of
loans decreases. Similarly, business will increase the investment as cost of loans
decreases. In this case, both consumption and investment will increase, AD will
increase. According to Keynesians, if there is a tax cut, consumer will have more
disposable income so that they will consume more goods and services. There may be
an autonomous increase in business investment or government expenditure so that
AD will increase.
According to the diagram, AD shifts to AD’, price level increases from P1 to P2 at
full-employment level of output.
Cost-push inflation occurs when there is a decrease in aggregate supply which is not
matched by a decrease in aggregate demand. If exchange rate depreciates, price of
import increases. Thus, the price of imported raw materials will rise, cost of
production becomes higher. On the other hand, if there is an increase in trade union
bargaining, wage rate will increase. If it is not matched by the improvement of
labour productivity, cost of production will also increase.
According to the diagram, AS shifts to AS’, price level increases from P1 to P2, real
GDP decreases from Y1 to Y2.
(381 words, 2 diagrams)
17S1 Explain how a fall in an economy's foreign exchange rate can cause both
cost-push and demand-pull inflation. [8]
Plan
P1 Define AD, AS and inflation
P2 Explain link between depreciation and demand-pull inflation
P3 Explain link between depreciation and cost-push inflation
Sample
Aggregate demand (AD) is the total spending on an economy’s goods and services at
a given price level in a given time period. It has 4 components: consumption,
investment, government spending and net export. AD=C+I+G+(X-M). On the other
hand, aggregate supply (AS) is the total supply in the economy. It is the total amount
of goods and services that firms are willing and able to sell at a given price level in an
economy. Inflation is the sustained rise in price level over a period of time. There are
two types of inflation: demand-pull inflation and cost-push inflation. A fall in foreign
exchange rate will cause both types of inflation.
Demand-pull inflation occurs when there is an increase in aggregate demand which
is not matched by an increase in aggregate supply. This is likely to be the case when
an economy is at a situation of full employment. If exchange rate depreciates, price
of export will fall while price of import will rise. As price of export decreases, if PED
of export is elastic, total revenue of export will increase. Similarly, as price of import
increases, if PED of import is elastic, total revenue of import will decrease. As net
export is a component of AD, this will lead to demand-pull inflation.
According to the diagram, AD shifts to AD’, price level increases from P1 to P2 at
full-employment level of output.
Cost-push inflation occurs when there is a decrease in aggregate supply which is not
matched by a decrease in aggregate demand. This may rise due to an increase in the
prices of raw materials and wages. As the exchange rate depreciates, price of
imports become more expensive, the cost of raw materials will increase. For
example, if there is an increase in price of oil, the transportation and construction
costs go up. Such increasing in costs are passed on to consumers by firms by raising
the prices of the products. This causes aggregate supply curve to shift leftward.
According to the diagram, AS shifts to AS’, price level increases from P1 to P2, real
GDP decreases from Y1 to Y2.
(352 words, 2 diagram)
17W1 Discuss the causes of an increase in aggregate demand. Assess whether such
an increase will always cause inflation. Use diagrams to support your answer. [12]
Plan
P1 Explain policy variables
P2 Explain exogeneous variables
P3 Discuss whether inflation will occur or not
P4 Conclusion
Sample
Government policies can affect different components of aggregate demand.
Expansionary monetary policy will increase AD. Increase in money supply will reduce
interest rate. As a result, the return of saving money decreases, consumer may not
save money in the bank and increase consumption. Meanwhile, it is cheaper to
borrow money from the bank; consumer may purchase cars or houses as the cost of
loans decreases. Similarly, business will increase the investment as cost of loans
decreases. In this case, both consumption and investment will increase, AD will
increase. Lower interest rate will also reduce exchange rate. If exchange rate
depreciates, price of export will fall while price of import will rise. As price of export
decreases, if PED of export is elastic, total revenue of export will increase. Similarly,
as price of import increases, if PED of import is elastic, total revenue of import will
decrease. As net export is a component of AD, AD will increase as well. On the other
hand, expansionary fiscal policy will also increase AD: increases in government
purchases of goods and services directly increase spending; tax reductions or
increases in transfers raise disposable income and induce higher consumption.
Apart from government policies, exogenous factors would also increase AD. For
instance, if there is an increase in economic growth rate in foreign economies, net
exports will increase due to higher demand. Rise in stock market increases
household wealth and thereby increases consumption; also, higher stock prices
lower the cost of capital and thereby increase business investment. Technological
advances can open up new opportunities for business investment, such as railroad,
the automobile and computers.
Demand-pull inflation occurs when there is an increase in aggregate demand which
is not matched by an increase in aggregate supply. This is likely to be the case when
an economy is at a situation of full employment.
According to the diagram, AD shifts to AD’, price level increases from P1 to P2 at
full-employment level of output.
However, if the economy is not at its potential output, expansionary monetary policy
and fiscal policy will also increase AS. If AS increases faster than AD, price level will
decrease. On the other hand, Keynesian argues that there are depression and mass
unemployment at low levels of income. As labour will have difficulties in bidding up
wages and firms will have excess capacity, costs in firms do not rise when output
increases. In this case, LRAS is perfectly elastic so an increase in AD will not cause
inflation.
To conclude, expansionary and monetary policies will increase AD. If an increase in
AD is not matched by an increase in AS, it will lead to inflation.
(441 words, 1 diagram)
10W1 Discuss the methods and problems involved in constructing an accurate
measure of the rate of inflation. [12]
Plan
P1 Define inflation and CPI
P2 Explain construction of CPI
P3 Explain problems of construction of CPI
P4 Conclusion
Sample
Inflation is the sustained rise in price level over a period of time. The rate of inflation
is defined as the rate of change of the general price level. The most widely used
measure of the overall price level is the consumer price index, also known as the CPI.
The CPI measure of inflation starts by sorting through a large collection of survey
data from which a basket of goods and services is formed to reflect the consumer
habits of the average family in a nation. These goods and services are then weighted
according to the quantity bought by multiplying the average price of the good or
service by the weight to provide a weighted value of the basket when all the prices
are added up. A base year is selected, where the raw value of the basket in that year
is given the index value of 100. Annual changes in the raw value of this basket are
indexed and compared to the base year with a simple percentage change calculation
between annual index figures generating the inflation rate year on year.
Each year the basket of goods and services is updated to reflect changes in consumer
habits and weights are changed to reflect changes in the proportion of income spent
on basket goods and services.
However, there are a number of potential problems in the use of price indices. The
basket of goods and services generated will not necessarily reflect the consumption
habits of all consumers in the economy. Each consumer will not purchase every item
in the basket and will not spend the same proportion of their income on items
exactly as they have been weighted. The best example of this would be comparing
high-income earners to low earners. High income earners will spend money on
luxury goods such as foreign holidays whereas for low income earners bus travel may
be a majority purchase. Therefore, if the price of foreign holidays shot up
considerably and fed through to a higher inflation rate, this would not be felt by low
income earners and thus the inflation rate rise would not be representative of all
consumers. On the other hand, there will always be issues with how quickly the
basket of goods and services is changed according to changes in the consumption
habits of a nation. For the CPI to represent inflation for all households, the basket
must be as up to date as possible and therefore changed regularly. If this is not done
regularly due to financial pressures or done incorrectly, the inflation figures
generated may not be reflective of current consumer habits and price changes of
items actually bought. The CPI basket is also prone to seasonal fluctuations that can
drastically impact the prices of key goods and services that are weighted heavily and
therefore contribute to inflation, such as gas, petrol and food. A very cold winter
may artificially push up gas prices and excessive summer rains may push up food
prices both of which will increase inflation yet these are seasonal factors which can
lead to a fluctuating CPI inflation rate without providing a sense of the underlying
trend in prices throughout the rest of the economy.
To conclude, we could use CPI to measure inflation rate. As different consumers
have different spending pattern, it’s difficult to use this single index to measure the
inflation rate.
(560 words)
19S3 Discuss the most serious problems faced by an economy with a high and
increasing rate of inflation. [12]
Plan
P1 Explain internal effects
P2 Explain external effects
P3 Evaluate which is most serious
P4 Conclusion
Sample
A high and increasing rate of inflation is a serious economic problem as there are a
number of negative consequences in internal economy. The real value of money will
fall under high rate of inflation. This has two negative impacts. Firstly, the purchasing
power of money will fall. Those who are on fixed incomes will suffer a decrease in
their real income, this will decrease consumption in the economy and the overall
level of aggregate demand. Secondly, there are shoe leather costs. This is where
individuals receiving fixed interest rates on their savings look for better places to
earn a positive real rate of return. Those income could be used to improve
productivity so that there is a large opportunity cost. There are also menu costs, this
is where menus, catalogues and labels all need re-printing as a result of high inflation.
The costs of doing this are substantial in terms of time requirements, labour costs
and the physical costs of printing. There will be redistribution of incomes: borrowers
gain and lenders lose during inflation because debts are fixed in rupee terms. When
debts are repaid their real value declines by the price level increase. Hence, creditors
lose. High rate of inflation also distorts the use of money. In a period of
hyperinflation, money loses all of its value, people no longer use money as a medium
of exchange. Sellers will no longer be willing to accept it in exchange for purchases.
Producers will state the value of their goods in terms other than money, such as
commodity money or foreign currency. Money could not function as unit of account
as well.
There are also negative external effects of high and increasing rate of inflation. As
inflation increases, the competitiveness of domestic exports decreases, reducing the
demand and the revenues generated from them. Furthermore, imports become
more competitive relative to domestic goods and services. Both effects worsen the
current account position in the economy, which will reduce AD and decrease
economic growth. If a country runs a large amount of current account deficit, there
will also be foreign debt, government need to borrow money to finance this deficit,
the economy may be very weak. Current account deficit will lead to a fall in
exchange rate because of the fall in demand for exports and rise in demand for
imports. A depreciation in the exchange rate will lead to financial outflow due to lack
of confidence of foreign investors.
Which problems could be considered most serious depend on several factors. If a
country is not an open economy, for example, North Korea, there will be limited
external effects. As a result, internal consequence is more serious. On the other
hand, if other countries have a relatively higher inflation than local country, export
goods will not lose international competitiveness. As a result, Export will not
decrease. The problem related to trade deficit will not occur. Therefore, I argue that
the most serious problem of inflation is its internal effects, especially when investors
become reluctant to invest in their business and to make long-term commitments.
This will adversely affect the growth performance of the economy.
(511 words)
15S3 Discuss the impact of a high rate of inflation on the consumers and producers
in an economy and assess whether consumers or producers would suffer more.
[12]
Plan
P1 Define high rate of inflation
P2 Explain effects on consumers
P3 Explain effects on producers
P4 Evaluate who would suffer more
P5 Conclusion
Sample
High inflation will decrease real income and increase the cost of living because
increase in price level will reduce the purchasing power. As low-income households
spend a large proportion of their income on necessary goods, they will be affected
more than the rich people. There will be redistribution of income: borrower will gain
while lender will lose. This is because borrowers will pay back less in real terms and
lenders will receive if the rate of interest does not change.
However, not all consumers will suffer under high inflation. Inflation reduces the
burden of debt. Real interest rates may fall due to inflation. This is because nominal
interest rate does not tend to rise in line with inflation. For example, those who have
borrowed money to buy a house may experience a fall in their mortgage payments in
real terms. A reduction in debt burden may stimulate consumer expenditure.
For producers, there will be menu costs. Menu costs are the costs involved with
changing the nominal prices of goods and services to reflect inflation. Firms need to
print new menus or change categories if there is high rate of inflation. This involves
staff time and is unpopular with customers. There will also be shoe leather costs.
Shoe leather costs are the costs involved in moving money from one financial
institution to another in search of the highest rate of interest. This is because they
are unwilling to hold large amounts of cash due to high rate of inflation.
For exporters, inflation causes goods and services to be expensive compared to
other countries. At the same time, imported goods are becoming relatively cheaper,
consumer will switch to buy imports. This will lead to a decrease in export and fall in
exporter’s revenue. Due to lack of demand of domestic products, unemployment will
increase as well.
However, not all producers are loss under high inflation. The profits of firms could
increase if prices rise more than costs, and in this situation they could be encouraged
to expand, reducing the level of unemployment in an economy. Firm could use these
profits to invest in capital goods, this could reduce cost of production and gain
higher market share.
Whether consumers or producers would suffer more depend on several factors. If
other countries have a relatively higher inflation than local country, export goods will
not lose international competitiveness. As a result, Export will not decrease. The
problem related to exporters will not occur. High rate of inflation will cause
depreciation in the exchange rate. This will reduce the price of export and restore
competitiveness of export, thus offsetting the external consequence of inflation. On
the other hand, if a country is not an open economy, for example, North Korea,
there will be limited external consequence. In this case, both consumers and
producers may suffer from high rate of inflation.
To conclude, if the country has a higher rate of inflation than its trading partners,
exporters will suffer more than consumers as their products may lose international
competitiveness.
(502 words)
10W3 Explain why a low and stable rate of inflation may be beneficial to an
economy. [8]
Plan
P1 Define inflation
P2 Explain benefits of low inflation
P3 Explain benefits of stable inflation
Sample
Inflation is the sustained rise in price level over a period of time. The rate of inflation
is defined as the rate of change of the general price level. The most widely used
measure of the overall price level is the consumer price index, also known as the CPI.
If inflation rate is positive, CPI will rise.
Inflation can be beneficial if at a low and stable rate and caused by aggregate
demand increases. As price level increases, firms are encouraged to produce more
output as they could increase their revenues and potentially profits year by year.
This will increase employment as well because firms need to hire worker to produce
goods and services. Inflation also encourages consumers to buy whenever they need
goods and services rather than delay or bring forward their spending. On the other
hand, a low rate of inflation will allow the economy to remain competitive in
international markets. If the country has relatively lower rate of inflation than its
trading partner, the exports will become relatively cheaper so that more goods could
be sold internationally. This will improve the current account position of the
economy and bring in more foreign reserves.
On the other hand, a stable rate will bring certainty for producers. The most
important decisions taken by individuals and businesses alike are usually long-term
decisions: a decision to build a factory, to start a business, to pursue an education, to
own one's home. These decisions crucially depend on the degree of uncertainty
regarding the future. Low and stable inflation is a macroeconomic indicator for
stability that contributes greatly to the confidence of people and businesses for
making investment decisions. This will also minimise shoe leather costs: producers
are no longer required to find appropriate investment to keep their value of assets.
Firms, individuals and governments will be able to plan effectively because they
could accurately estimate the costs or revenue if the inflation rate is stable rather
than fluctuate.
(325 words)
19W1 Discuss whether deflation is more of a problem in an economy than inflation.
[12]
Plan
P1 Explain problems of deflation
P2 Explain problems of inflation
P3 Evaluate which one is more serious
P4 Conclusion
Sample
Deflation could be extremely dangerous for an economy if it comes from a lack of
aggregate demand in the economy. As price level continues to decrease, consumers
will predict further price falls so they would not consume the goods until they think
prices have hit their floor. As a result, producers’ revenue will decrease, lead to a fall
in level of investment and employment. In addition, real interest rates during periods
of deflation are always positive. Consumers always have the incentive to save, which
will add to persistent falls in aggregate demand. Finally, deflation will increase the
real value of debt. This is because debt is fixed with the full value needing to paid
back while the purchasing power of money increases during the period of deflation.
For firms, their level of profits is decreasing, marking it harder to services their debts
too. If a large number of firms go bankruptcy, financial crisis and banking collapse
may occur so that the economy is extremely difficult to overturn.
On the other hand, a high rate of inflation is a serious economic problem as there
are a number of negative consequences in internal economy. The real value of
money will fall under high rate of inflation. This has two negative impacts. Firstly, the
purchasing power of money will fall. Those who are on fixed incomes will suffer a
decrease in their real income, this will decrease consumption in the economy and
the overall level of aggregate demand. Secondly, there are shoe leather costs. This is
where individuals receiving fixed interest rates on their savings look for better places
to earn a positive real rate of return. Those income could be used to improve
productivity so that there is a large opportunity cost. There are also menu costs, this
is where menus, catalogues and labels all need re-printing as a result of high inflation.
The costs of doing this are substantial in terms of time requirements, labour costs
and the physical costs of printing.
There are also negative external effects as well. As inflation increases, the
competitiveness of domestic exports decreases, reducing the demand and the
revenues generated from them. Furthermore, imports become more competitive
relative to domestic goods and services. Both effects worsen the current account
position in the economy, which will reduce AD and decrease economic growth. If a
country runs a large amount of current account deficit, there will also be foreign
debt, government need to borrow money to finance this deficit, the economy may
be very weak. Current account deficit will lead to a fall in exchange rate because of
the fall in demand for exports and rise in demand for imports. A depreciation in the
exchange rate will lead to financial outflow due to lack of confidence of foreign
investors.
Whether inflation is more serious than deflation depends on several factors. A low
level of demand-pull inflation may have more benefits than costs. This is because as
price level increases, firms are encouraged to produce more output as they could
increase their revenues and potentially profits year by year. This will increase
employment as well because firms need to hire worker to produce goods and
services. Inflation also encourages consumers to buy whenever they need goods and
services rather than delay or bring forward their spending. On the other hand, a low
rate of inflation will allow the economy to remain competitive in international
markets. If the country has relatively lower rate of inflation than its trading partner,
the exports will become relatively cheaper so that more goods could be sold
internationally. This will improve the current account position of the economy and
bring in more foreign reserves. However, if the inflation rate is high, money loses all
of its value, people no longer use money as a medium of exchange. Sellers will no
longer be willing to accept it in exchange for purchases. Producers will state the
value of their goods in terms other than money, such as commodity money or
foreign currency. Money could not function as unit of account as well. Therefore, I
argue that deflation is more of a problem than a low rate of inflation while a high
rate of inflation may harm the economy more.
(711 words)