Chapter 31
INFLATION AND DEFLATION
Inflation and Deflation
• Inflation is the rate of increase in prices over a given
period of time. Inflation is typically a broad measure,
such as the overall increase in prices or the increase in
the cost of living in a country.
• Deflation is when the prices of goods and services
decrease across the entire economy, increasing the
purchasing power of consumers. It is the opposite of
inflation and can be considered bad for a nation as it
can signal a downturn in an economy.
Consumer Price Index (CPI)
• Consumer price indexes (CPIs) are index numbers that
measure changes in the prices of goods and services
purchased or otherwise acquired by households,
which households use directly, or indirectly, to satisfy
their own needs and wants.
• The CPI is the most widely used measure of inflation,
closely followed by policymakers, financial markets,
businesses, and consumers.
Weighted Price Index
• A price-weighted index is a stock index in which each
company included in the index makes up a fraction of
the total index proportional to that company's share
stock price per share.
Cost-Push Inflation
• Cost-push inflation (also known as wage-push
inflation) occurs when overall prices increase
(inflation) due to increases in the cost of wages
and raw materials. Higher costs of production can
decrease the aggregate supply (the amount of total
production) in the economy. Since the demand for
goods hasn't changed, the price increases from
production are passed onto consumers creating cost-
push inflation.
Demand-Pull Inflation
• When demand for goods or services rises faster than the
supply of those goods and services, the result is demand-
pull inflation. Demand-pull inflation is when there is an
increase in aggregate demand, and the supply remains
the same or decreases.
• For example, if manufacturing tires suddenly becomes
twice as expensive, the prices of those tires will also
increase, causing inflation. This could even affect the car
market, as car manufacturers will need to pay more to
complete their vehicles
Consequences of Inflation
• It causes a fall in the value of money
• Redistributes income in an unplanned way
• Imposes extra costs on firms
• Creates uncertainty
• Harm the country’s balance of payments position
• Can cause fiscal drag
The beneficial Effects of
Inflation
• inflation may encourage firms to expand. A low and
stable level of demand-pull inflation may make
entrepreneurs optimistic about future sales.
• inflation reduces the real burden of any debt that
households and firms have built up. This may mean
that some households and firms will avoid going
bankrupt.
• inflation can prevent some workers being made
redundant in a declining industry or region. This is
because whilst workers are likely to resist any cut in
their money wages, they may accept their money
wages rising by less than inflation. In such a case,
firms' real wage costs will fall without resorting to a
retrenchment of workers.
Causes of Deflation
• Fall in the money supply
• Decline in confidence
• Lower production costs
• Technological advances
• Increase in unemployment
• Increase in the real value of debt
• Deflation spiral
Consequences of Deflation
• Decrease in consumer spending
• Increase in real debt burden
• Difficulty for firms to raise prices
• Difficulty in monetary policy
• Rise in unemployment