IB Economics

Ch 19 Inflation and Deflation

Background to Inflation

• Inflation: a sustained increase in the general price level– CPI (HICP)

• A weighted index of 14 categories: Family Expenditure Survey

• The UK official inflation figure• Price stability defined as 2% CPI inflation• Symmetrical target (compared with asymmetric ECB)

– RPI & RPIX• Why have these old measures become popular during the

recession?

Index numbers

• Base year =100– 2005: 100– 2006: 105– 2007: 110– 2008: 115– 2009: 121

TASK: Calculate the year on year inflation rates for the example above and comment on your findings.

Latest CPI & RPI figures for the UK

CPI 1989 (pre 2007 estimated) to 2009

RPI 1948 - 2009

Causes of inflation

• Internal factors– Changes in sales taxes e.g. VAT– Strength of AD– Pricing strategies by domestic firms

• External factors (or shocks)– Rising imported raw materials– Inflation in other countries– Strength of other economies

• Demand pull• Cost push• Excessive growth of the money supply (see Milton

Friedman)

Cost push inflation

• A rise in costs of imported raw materials– e.g. oil

• Rising labour costs – e.g. trade unions

• Higher indirect taxes– How will the increase in VAT in January 2010 affect

the UK economy?

• Wage price spiral– How do expectations affect wage negotiations?

Cost push AS/AD diagram

TASK: Complete the diagram

Demand Pull

• Lack of spare capacity– e.g. factories cannot expand

• Too much money chasing too few goods– e.g. Increases in pay that are not linked to

increased production

• Consider what happens in an auction– Limited supply, there can only be one winner

but at a higher price

Demand Pull

TASK: Complete the diagram

Growth in the Money Supply

TASK: Complete the diagram

Consequences of inflation

– International competitiveness– Effect on investment– Unanticipated inflation– Menu costs– Shoe-leather costs– Effects on distribution of income– Worsening of industrial relations– Fiscal drag– Hyperinflation

So if inflation is so bad why do we target inflation to be positive and worry about it being too low?

Deflation

• A fall in the general • BAD Vs GOOD deflation• Unemployment• The effect on debt levels• The effect of delayed spending• The effect on investment• Recent examples

– Japan late 1990’s– India 2009– UK 2009? If you consider RPI

Source: http://news.bbc.co.uk/2/hi/business/7955931.stm

How do we reduce inflation and avoid deflation?

• Monetary Policy– Interest rates– Minimum reserve ration– Quantitative easing

• Fiscal Policy– Changes in spending– Changes in taxation

• Supply-Side Policy

Controlling Inflation - FISCAL

TASK: Complete the diagram

Controlling Inflation - MONETARY

TASK: Complete the diagram

Controlling Inflation - SS

TASK: Complete the diagram