Transcript You owe…. - Baffled Bee

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 INFLATION
SRAS2
LRAS
Price Level
SRAS
AD1
AD
0
Y1
Y2
Real National
Output
In the LR,
workers are not
willing to
sacrifice Leisure
time for more
overtime…. But
still have high
wage
expectations….
demand pull
inflation
Recap
• Can you draw me a cost push inflation
diagram (show SR & LR AS)
Draw an Classical AD/AS
diagram
LRAS
Price Level
SRAS2
SRAS1
AD
0
Y2
Y1
Real National
Output
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 products
Price deflation in many markets for UK consumers
Annual percentage change in the consumer price index for selected items
0.0
-2.0
Clothing and Footwear
-4.0
1996=100
-6.0
-8.0
-10.0
-12.0
Audio-visual and photo equipment
-14.0
-16.0
Oct Jan Apr Jul
01
02
Oct Jan Apr
Jul
03
Oct Jan Apr
Jul
04
Oct Jan Apr
Jul
05
Oct
Source: Reuters EcoWin
What’s the
Consumer Price Inflation for Goods and Services
start the
&
Annual Percentage Change
What’s
end
points?
trend?
6
5
Inflation in Services
4
Describe the changes
in the data provided.
Percent
3
2 Goods and Services Together
1
0
-1
Inflation in Goods
-2
-3
00
01
All items (CPI), Chg Y/Y
All goods, Index [ar 12 months]
02
03
04
All services, Index [ar 12 months]
05
What effects do you
think06this had on the
economy?
Source: Reuters EcoWin
The diagrams
– demand side cause of deflation
DEMAND PULL Deflation…
LRAS
Price Level
SRAS
AD1
0
Y2
Y1
AD
Real National
Output
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
B
C
D
business pessimism.
the savings ratio.
spare capacity.
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’ deflation
LRAS
Price Level
SRAS1
SRAS2
AD
0
Y1
Y2
Real National
Output
LR Cost ‘push’ deflation
LRAS
Price Level
LRAS
SRAS1
AD
0
Y1
Y2
Real National
Output
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!
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
QUESTIONS
1.
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?