The Study of Inflation

GPL0

GPL1

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Definition

“General and sustained rise in the level of prices of goods and services.”

Moynihan

To calculate rate of price inflation, we calculate the average percentage change in the prices of all goods and services, from one point in time to another, usually from 1 quarter to another or from 1 year to another.

Calculating of Inflation

Calculation of Inflation

We usually track the price fluctuation of a basket of goods.

In the case of Singapore the basket of goods consist of 6,500 brands or variety of goods and services.

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Calculation of Inflation

Using a Weighted Average Price Index

Year 0 – Base Year

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Calculation of Inflation

Using a Weighted Average Price Index

Year 1 – (1 year after the base year)

Calculation of Inflation

Year CPI Infltion Rate

2000 2000 0

2001 2500 A

2002 3000 B

Qn 1: What is the inflation rate year on year (yoy) from 2000 to 2001 and from 2001 to 2002?

Qn 2: What is the inflation rate year at the end of 2002 as compared to the base year?

2000 – 2001 is 25%: (2500 – 2000)/2000 X 100 2001- 2002 is 20% : (3000 – 2500)/2500

Base year 2000 to 2002 is 50% (3000 – 2000)/2000X 100

(Non weighter average)

Reasons Why High Inflation Is Not Good for an Economy

1.Purchaing Power will fall. People will save less and instead spend now as the value of their money will be less. With less savings, the banks will have less funds to lend to firms for investments and as such economic growth will be hindered.2.Reduces competiveness of firms and is highly inconvenient as firms have to constantly change their pricing3.A country can lose its export competitiveness as compared to the lower cost product of other countries exports4.Diminishes the value of Money.a. Money as a medium of exchange for goods and services will become unreliable.b. Money as a unit of account – how many goods money can buy has to be constantly adjusted as less and less can be boughtc. Money as a store of value – The same amount of money can buy less goods. People will find their savings eroded when prices rise.d. Money as a standard of deferred payment – Banks will give less loans and business will give less credit payment as the value of money they received later will be less than what they lend to them in the beginning.

Is Inflation Always Bad for the Economy?

Mild inflation (less than 5% increase in GPL) is beneficial to the economy as it is a signal to producers that there is growth in the economy and as such profits to be made thereby causing them to increase production.

AS

Is Inflation Always Bad for the Economy?

Galloping(double / triple digit increase) or hyper (1000% increase) inflation however is not good for the economy.

AS

The Long Run Aggregate Supply Curve

1. So far you have assumed that all AS is upward sloping:

SRAS The AS that we have used so far is in fact a short run AS (SRAS) where we can increase the use of existing resources up to the limit of a country’s resources.

Qn: But in the long run, were resources is limited, how does the long run AS (LRAS) look like? Hint: How does the supply curve for a crop, like rice, look like (think of gestation period)

LRAS

As such when AD increases, there will be no increase in ouput (no GDP growth) as the LRAS is vertical.

LRAS

AD0

AD1

Demand Pull Inflation

This type of inflation happens when there has been excessive growth in aggregate demand and there is an inflationary gap (A-B)

Definition:Demand Pull inflation occurs when aggregate demand, for goods and services exceeds aggregate supply. ie: AD (point B) > AS (point A)

AD1

AD0

GPL0

GPL1 SRAS

A

B

1. Excessive expenditure from C,I,G & X. causes AD to shift to the right

LRAS

2. When AD increases and shift from AD0 to AD1 it give rise to increase in GPL

signaling demand pull inflation.

Demand Pull Inflation Application Question.

Qn: Explain, using an AD/AS diagram, how increasing income of the Chinese citizens has caused demand pull inflation to arises in China.

To Hand UpDylan KohDilan LeeWinnieXanMelvinXinyu

Barclay's Bank is presenting the following question today. The question is:

"With the aid of a diagram, evaluate the effectiveness of demand side policies to make exports more competitive in a country that is suffering high inflation" (8 marks).

Demand Side Policy Application Question

*Members from Sumitomo and Deutsche Bank are to comment.

AD1AD

GPL0

GPL1

SRAS

A

B

Cost Push Inflation

Representation. This can be shown by an inward shift of the short run aggregate supply curve which leads to a contraction in the real output (and economic growth), an also an increase in the general price level.

Definition: Sustained increase in price of goods and services, caused by the passing off increased production costs to the consumers by the producers.

Causes of Cost Push Inflation

1. Increase in the prices of factors of production eg. Fuel Oil, Resource like plastics, tin, copper that is required for the production process. If these resources are imported at a higher price, we call this imported inflation.( be careful of misconception here – nothing to do with AD imports here)

2. Increase in the wages of labour. ( We call this wage push inflation)

3. Firms desiring to increase push for profits and hording resources (as in a monopolistic or oligopolistic market structure) causing prices of goods to increase.

Imported inflation, wage push and profit push are all different form of cost push inflation.

Cost Push Inflation - Solution

AD1AD

GPL1

GPL0

SRAS

A

B

Solution to Cost Push Inflation:

?SUPPLY SIDE

POLICIES

Cost Push Inflation – Teaser 11. The international price of fuel oil has increase by 15% since last year. Explain how this will affect Singapore’s exports?

Ans: As fuel oil is imported by domestic firms as a factor of production, an increase in price will increase the cost of production of many firms giving rise to imported inflation (a form of cost push inflation)

This implies a leftward shift of the SRAS curve upwards (or leftward) giving rise to an increase in GPL.

Ultimately the prices of Singapore exports will become more expensive vis-à-vis imports causing Singapore exports to lose its competitiveness.

Hand Up

Dilan Koh Dylan LeeEuniceMandy HoMelvinAdiAmelia (pls remember to write the question)

Gen to present

Cost Push Inflation – Teaser 22. The government of China recently decided to remove the monopoly power of state owned enterprises. Explain how this would benefit China’s exports. (5 points)

Ans: A monopoly market structure is such that the monopolist is able to reduce production and cause prices to increase as the monopolist maximizes profits. (1)This gives rise to cost push inflation. (1)

By removing monopoly power, the government is increasing competition(1) in the market (this is a supply side policy) causing firms to use resources more efficiently thereby achieving allocative and productive efficiency (1). Domestic Chinese firms can produce cheaper goods/services as compared to imports. This increases the export competitiveness of Chinese goods and will give rise to greater economic growth. (1)

Hand Up

GinaBerniceBenedictCharmainAngieAlexSue NingKenneth (pls remember to write the question)

Wit to process this answer.

(*red words are required key phrases)