Inflation & Deflation

Reference 13.1 and 13.2

Aggregate=all together

• Aggregate demand and aggregate supply considers the entire quantity of goods and services in an economy.

• The equilibrium price in aggregate supply and demand curves is called the price level.

P

Q

S1D1

Inflation / DeflationWhat is it?an increase in the price levela decrease in price levelHow is it determined?by comparing the CPI in different years and

noting the changeCPI is higher=inflationCPI is lower=deflation

CPI= Consumer Price Index

• Last year’s CPI (based on 1984 prices)

$216.17

• This year’s CPI

$218.70

• Inflation rate

3.82%3.82%

Can be caused by supply-side shifts or demand-side shifts

• Under what conditions would you expect to see inflation (rise in price level)?

• Under what conditions would you expect to see deflation (fall in price level)?

Inflation can be caused by an increase in aggregate demand

woohoo!!more people!!more money!!

Inflation can be caused by a decrease in aggregate supplyoilgrain

Deflation can be caused by a decrease in aggregate demand

Deflation can be caused by an increase in aggregate supply

Simple Quantity Theory of Money

• If velocity and quantity of output (supply) are constant, more money in circulation leads to higher prices.

What does velocity mean?

velocity=the average number of times per year a dollar is spent to buy final goods

Simple Quantity Theory of Money

• If velocity and quantity of output (supply) are constant, more money in circulation leads to higher prices.

M x V = P x QM x V = P x Q

M = money supplyV = velocityP = price levelQ = quantity of output

% change M = % change P% change M = % change P

Inflation Rates between 1952 and 2008

• Low levels of unemployment are frequently periods of higher inflation

More working people with more money

(increase in aggregate demand)

remember Monetary PolicyMonetary Policy??

• The goal is to maintain price stability and low unemployment.

Monetary PolicyMonetary Policy

• Fed is responsible for maintaining price stability and employment

• “Expansionary Monetary Policy” – goal is to increase money supply

• to reduce unemployment• to avoid deflation

• “Contractionary Monetary Policy”– goal is to decrease the money supply

• to reduce inflation

So What?• Negative Effects of Inflation

– hurts people on fixed incomes (the retired)– hurts savers– hurts lenders (helps debtors)– hurts people who contract to be paid in the future– makes financial decision making more difficult

• hedging = avoiding or lessening a loss by taking a counterbalancing action.

– buy gold or some other store of value besides money

So What?• Negative Effects of Deflation

– Great Depression!Great Depression!– uneven fall in prices

• business failures• job loss

– hurts debtors– hurts property-owners

Stagflation• stagnant (persistently high) unemployment

and• inflation

1970’s US and other industrialized nations experienced stagflation• erratic monetary policy: stop-and-go, on-and-off • supply shocks (OPEC)

What’s up with that?

Review

• What are some possible causes of inflation?

• What are some possible causes of deflation?

• Why is the relationship between unemployment and inflation usually inverse?

• Why is inflation a problem?

Review

• How does the “the fed” use monetary policy to control inflation?

Homework

• Read Chapter 14 Business Cycles and Economic Growth pps. 364-386– Complete Review Sections p.386-387

• Economics Vocabulary (writing complete sentences)• Review Questions• Analyzing Primary Sources

– Be prepared to take a chapter quiz

Today’s Exit Pass

• In a small group, read 13.3 “Unemployment”

• Section Review p. 359• #1 Definitions• #2-3 (complete sentences)