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Inflation & DeflationInflation & Deflation

Recap & move forward…Recap & move forward…

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RecapRecap

• What was the more recent ‘FIVE’ causes of UK’s rise in inflation last month?

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RecapRecap

• What was the more recent ‘FIVE’ causes of UK’s rise in inflation last month?

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

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RecapRecap

• In theory – what are the 2 different types of inflation?

–Demand pull inflation–Cost push inflation

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RecapRecap

• Can you draw me a demand pull inflation diagram (show SR & LR AS)

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DEMAND PULL INFLATIONDEMAND 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

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RecapRecap

• Can you draw me a cost push inflation diagram (show SR & LR AS)

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Draw an Classical AD/AS Draw an Classical AD/AS diagramdiagram

Price Level

Real National Output

Y1

LRAS

0

AD

SRAS1

SRAS2

Y2

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DeflationDeflation

Is it good or bad?Is it good or bad?

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DeflationDeflation

• Deflation is a sustained fall in the general price level

• A sustained period of negative inflation

• The internal value of money rises

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Deflation for some productsDeflation for some products

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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?

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The diagramsThe diagrams

– – demand side cause of deflationdemand side cause of deflation

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DEMAND PULL Deflation…DEMAND PULL Deflation…Price Level

Real National Output

Y1

LRAS

Y2

AD1

0

AD

SRAS

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Demand side causes of DeflationDemand 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

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Multi choice…Multi choice…

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Demand-pull inflation is most likely Demand-pull inflation is most likely to be caused byto 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.

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

there is a rise inthere is a rise in

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

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Real incomes rise wheneverReal 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.

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Inflation articleInflation article

• Read

• use highlighters to select key positive & negative issues

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What’s so BAD about inflation?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 article identifies 4 problems of inflation. What are they?

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The diagramsThe diagrams

– – supply side cause of deflationsupply side cause of deflation

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SR Cost ‘push’ deflationSR Cost ‘push’ deflationPrice Level

Real National Output

Y1

LRAS

0

AD

SRAS1

SRAS2

Y2

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LR Cost ‘push’ deflationLR Cost ‘push’ deflationPrice Level

Real National Output

Y1

LRAS

0

AD

SRAS1

Y2

LRAS

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Supply side causes of deflationSupply 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.

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Deflation – good and bad points!Deflation – good and bad points!

Impact on

Households?Consumers?

Employees? Businesse

s?

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Consequences of DeflationConsequences 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

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Past paper practicePast paper practice

I would suspect that your exam I would suspect that your exam paper will be about recessionary paper will be about recessionary

issues – one being Deflation!issues – one being Deflation!

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QUESTIONSQUESTIONS

1. Explain what is meant by the term “deflation”. (4 marks)

2. With reference to Extract 1, explain the effect on GDP of the change in asset prices in 1990. (8 marks)

3. Explain why “deflation needn’t be all bad”? (line 28, extract 2) (8 marks)

4. With reference to the extracts, examine the problems associated with a long period of deflation. (12 marks)

5. Assess the relative effectiveness of using monetary and fiscal policy to move the economy out of a period of deflation. (12 marks)

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

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Or….Or….

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January 2006 - inflationJanuary 2006 - inflation

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The questionsThe questions