INFLATION & DEFLATION
Understanding Price Changes in the Macroeconomy
O-Level Economics: Government and the Macroeconomy
LEARNING OBJECTIVES
By the end of this lesson, you will be able to:
1 Define inflation and deflation 2 Describe measurement using price indices
3 Analyse causes of inflation 4 Discuss consequences of inflation
5 Analyse causes of deflation 6 Discuss consequences of deflation
7 Evaluate policy effectiveness 8 Explain policy conflicts
STANDARDS & RESOURCES
STANDARDS ADDRESSED
SYLLABUS: Cambridge IGCSE® and O Level Economics
SECTION: Section 4: Government and the macroeconomy
CHAPTER: Chapter 31: Inflation and deflation
RESOURCE
Cambridge IGCSE® and O Level Economics Coursebook By Susan Grant Pages 272–283
KEY CONCEPTS
Inflation Deflation
Consumer Cost-push
Prices Index Inflation
Demand-pull Menu & Shoe-
Inflation leather Costs
DEFINING INFLATION & DEFLATION
INFLATION DEFLATION DISINFLATION
Rise in prices of goods and services Sustained fall in prices of goods Fall in rate of inflation
over time and services
Example: 10% to 7%
Rise in general price level Negative inflation
IMPORTANT TIP
If inflation falls (e.g., 8% to 6% ), the general price level is still rising, just at a slower rate
MEASURING PRICE CHANGES
CONSUMER PRICES INDEX (CPI)
Weighted average of prices of a representative basket
of goods and services
Shows percentage change in general price level over
time
CONSTRUCTING A PRICE INDEX
1 Select Base Year 2 Household Spending
Stable year, value of 100 Identify commonly
for comparison bought goods and
expenditure weights
3 Attach Weights 4 Find Price Changes
Higher expenditure Collect regular price
proportion = higher quotes from retail
weight outlets
5 Construct Weighted Index
Multiply weights by new price index for each category and
sum to calculate overall change
CAUSES OF INFLATION
Inflation: Sustained increase in general price level
COST-PUSH INFLATION
Price rises caused by higher production costs
Wage increases Raw material costs Higher indirect taxes
Exchange rate depreciation
DEMAND-PULL INFLATION
Price rises caused by excess aggregate demand
Increased consumption Higher investment
Government spending Export growth
MONETARY INFLATION
Demand-pull inflation caused by excessive money
supply growth
HARMFUL EFFECTS OF INFLATION
Impact depends on rate, stability, relative rate to
other countries, and government reaction
FALLING INCOME
PURCHASING REDISTRIBUTION
POWER Unplanned redistribution of
Each unit of money buys income
fewer products
Hyperinflation Gainers: Borrowers
Loss of confidence Losers: Savers
INCREASED UNCERTAINTY
FIRM COSTS
Difficult to plan for future
Additional expenses for costs and profits
businesses
Menu costs
Shoe-leather costs
FISCAL DRAG BALANCE OF
PAYMENTS
Incomes "dragged" into
higher tax brackets Worsened trade balance
Exports more expensive
Reduced disposable income Imports cheaper
BENEFICIAL EFFECTS OF INFLATION
While inflation is generally seen as harmful, low and stable inflation can have benefits
STIMULUS TO REDUCED DEBT LOWER
PRODUCTION BURDEN UNEMPLOYMENT
Firms expand output when prices Real value of debt decreases over Strong aggregate demand often
rise faster than costs time accompanies lower
unemployment
Especially with low inflation Benefits borrowers
Phillips Curve relationship
IMPORTANT NOTE
These benefits are typically associated with low and stable inflation. High or volatile inflation tends to have
predominantly negative effects.
CAUSES & CONSEQUENCES OF DEFLATION
Deflation: A sustained fall in the prices of goods and services
GOOD DEFLATION
BAD DEFLATION
Supply-side induced Demand-side induced
CAUSES CAUSES
1 Technology advances 2 Higher productivity Falling aggregate
1 2 Reduced consumption
demand
3 Lower production costs
3 Lower investment
CONSEQUENCES
CONSEQUENCES
1 Consumer benefits 2 More goods/services
1 Output decline 2 Rising unemployment
3 Global competitiveness
3 Deflationary spiral
POLICIES TO CONTROL INFLATION
INFLATION RATE TARGET
Governments set targets for central banks (e.g., 2%) to
ensure accountability and manage expectations
DEMAND-PULL INFLATION
FISCAL POLICY MONETARY POLICY
Increase taxation Increase interest rates
Decrease government Reduce money supply
spending
COST-PUSH INFLATION
SUPPLY-SIDE SUBSIDIES
POLICIES Government subsidies to
Education & training firms
Labour market reforms High opportunity cost
Lower direct taxes
Deregulation
Privatisation
POLICIES TO COUNTER DEFLATION
GOOD DEFLATION
Supply-side induced
No counter-policies needed
REASONS
Economically beneficial
Increases productivity
Enhances competitiveness
BAD DEFLATION
Demand-side induced
FISCAL POLICY MONETARY POLICY
Decrease taxation Decrease interest rates
Increase government Increase money supply
spending
CHALLENGES
Very low interest rates Low consumer confidence
Low business confidence High debt burdens
POLICY CONFLICTS
Governments face policy conflicts when trying to
achieve multiple macroeconomic aims
FULL EMPLOYMENT vs. STABLE
PRICES
FULL EMPLOYMENT STABLE PRICES
Increase government Decrease government
spending spending
Lower interest rates Raise interest rates
Tax cuts Tax increases
Boost aggregate Control aggregate
demand demand
THE TRADE-OFF
Measures to reduce unemployment boost aggregate
demand
Higher demand encourages firms to expand and hire
more workers
Increased demand also puts upward pressure on prices
Creates trade-off between unemployment and inflation
(Phillips Curve)
GOVERNMENT PRIORITISATION
Governments must decide which aim to prioritise based on
problem scale, consequences, and public concern