Inflation & Deflation

Recap & move forward…

Recap• Name ‘FIVE’ causes of UK’s rise in

inflation.

Recap• F= Fuel• I = Imports create higher costs• V = VAT• E= exchange rates

Recap• In theory – what are the 2 different

types of inflation?

–Demand pull inflation–Cost push inflation

Recap• Can you draw me a demand pull

inflation diagram (show SR & LR AS)

DEMAND PULL INFLATIONPrice Level

Real National Output

Y1

LRAS

Y2

AD1

0

AD

SRAS

In the LR, workers are not

willing to sacrifice Leisure

time for more overtime…. But still have high

wage expectations….

demand pull inflation

SRAS2

Recap• Can you draw me a cost push

inflation diagram (show SR & LR AS)

Draw an Classical AD/AS diagram

Price Level

Real National Output

Y1

LRAS

0

AD

SRAS1

SRAS2

Y2

Deflation

Is it good or bad?

Deflation• Deflation is a sustained fall in the

general price level

• A sustained period of negative inflation

• The internal value of money rises

Deflation for some productsAnnual percentage change in the consumer price index for selected items

Price deflation in many markets for UK consumers

Source: Reuters EcoWin

Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct01 02 03 04 05

1996

=100

-16.0

-14.0

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

Audio-visual and photo equipment

Clothing and Footwear

Annual Percentage ChangeConsumer Price Inflation for Goods and Services

All items (CPI), Chg Y/Y All goods, Index [ar 12 months]

All services, Index [ar 12 months]

Source: Reuters EcoWin

00 01 02 03 04 05 06

Per

cent

-3

-2

-1

0

1

2

3

4

5

6

Goods and Services Together

Inflation in Services

Inflation in Goods

Describe the changes in the data provided.

What effects do you think this had on the

economy?

What’s the trend?

What’s the start &

end points?

The diagrams

– demand side cause of deflation

DEMAND PULL Deflation…Price Level

Real National Output

Y1

LRAS

Y2

AD1

0

AD

SRAS

Demand side causes of Deflation

• A Large (adverse) Fall in AD• Exogenous shocks to the economy• A global recession leading to a fall in

exports and investment• A rise in the exchange rate (leading to lower exports

and cheaper imports)• Declines in domestic and international asset prices

– Deliberate attempts by macroeconomic policy to reduce AD through tightening of fiscal and/or monetary policy

Multi choice…

Demand-pull inflation is most likely to be caused by

• A total spending exceeding productive capacity.

• B an increase in output.• C a rise in raw material prices.• D a rise in interest rates.

An economy is most likely to be in the boom phase of the trade cycle

when there is a rise in

A business pessimism.B the savings ratio.C spare capacity.D the demand for imports.

Real incomes rise whenever

A nominal incomes rise.B the price level rises by more than nominal incomes.C nominal incomes rise by more than the price level.D the rate of inflation slows down.

What’s so BAD about inflation?

• “RPI is an aggregate figure” – what does this mean?

• Why are interest rates on mortgages such an important monetary tool to control inflation?

• What is the difference between nominal and real prices?

• The identify 4 problems of inflation. What are they?

The diagrams

– supply side cause of deflation

SR Cost ‘push’ deflationPrice Level

Real National Output

Y1

LRAS

0

AD

SRAS1

SRAS2

Y2

LR Cost ‘push’ deflationPrice Level

Real National Output

Y1

LRAS

0

AD

SRAS1

Y2

LRAS

Supply side causes of deflation

• An Increase in Long Run Aggregate Supply• The supply potential of the economy has been

boosted by a series of beneficial shocks such as

• Impact of rapid technological advances• Reductions in the international prices of commodities and

capital goods• Higher productivity which drives down unit cost of

production

– Exploitation of economies of scale leading to lower LRAC• Excess supply in some industries due to over-investment in

new capital machinery i.e. deflation results from a persistent demand deficit over existing and potential productive capacity.

Deflation – good and bad points!

Impact on

Households?Consumers

?

Employees? Businesses?

Consequences of Deflation• Holding back on spending: • Consumers may opt to postpone demand if they expect

prices to fall further in the future

• Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on confidence– Mortgage payers on fixed mortgage interest rates will see the

real cost of servicing their debt increase

• The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices

• Lower profit margins: This can lead to higher unemployment as firms seek to reduce their costs.

• Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence –leading to further declines in AD. Higher savings can lead to the paradox of thrift

Past paper practice

QUESTIONS1. Explain what is meant by the term “deflation”.2. With reference to Extract 1, explain the effect on GDP of

the change in asset prices in 1990. 3. Explain why “deflation needn’t be all bad”? (line 28,

extract 2) 4. With reference to the extracts, examine the problems

associated with a long period of deflation. 5. Assess the relative effectiveness of using monetary and

fiscal policy to move the economy out of a period of deflation.

6. How might the continuing deflation in Japan affect the global economy?