Transcript A2 Economics

IB Economics
Ch 19 Inflation and Deflation
Background to Inflation
• Inflation: a sustained increase in the general
price level
– CPI (HICP)
• A weighted index of 14 categories: Family Expenditure
Survey
• The UK official inflation figure
• Price stability defined as 2% CPI inflation
• Symmetrical target (compared with asymmetric ECB)
– RPI & RPIX
• Why have these old measures become popular during the
recession?
Index numbers
• Base year =100
– 2005: 100
– 2006: 105
– 2007: 110
– 2008: 115
– 2009: 121
TASK: Calculate the year on year inflation rates for the example above and
comment on your findings.
Latest CPI & RPI figures for the UK
CPI 1989 (pre 2007 estimated) to 2009
RPI 1948 - 2009
Causes of inflation
• Internal factors
– Changes in sales taxes e.g. VAT
– Strength of AD
– Pricing strategies by domestic firms
• External factors (or shocks)
– Rising imported raw materials
– Inflation in other countries
– Strength of other economies
• Demand pull
• Cost push
• Excessive growth of the money supply (see Milton
Friedman)
Cost push inflation
• A rise in costs of imported raw materials
– e.g. oil
• Rising labour costs
– e.g. trade unions
• Higher indirect taxes
– How will the increase in VAT in January 2010 affect
the UK economy?
• Wage price spiral
– How do expectations affect wage negotiations?
Cost push AS/AD diagram
TASK: Complete the diagram
Demand Pull
• Lack of spare capacity
– e.g. factories cannot expand
• Too much money chasing too few goods
– e.g. Increases in pay that are not linked to
increased production
• Consider what happens in an auction
– Limited supply, there can only be one winner
but at a higher price
Demand Pull
TASK: Complete the diagram
Growth in the Money Supply
TASK: Complete the diagram
Consequences of inflation
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International competitiveness
Effect on investment
Unanticipated inflation
Menu costs
Shoe-leather costs
Effects on distribution of income
Worsening of industrial relations
Fiscal drag
Hyperinflation
 So if inflation is so bad why do we target inflation to
be positive and worry about it being too low?
Deflation
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A fall in the general
BAD Vs GOOD deflation
Unemployment
The effect on debt levels
The effect of delayed spending
The effect on investment
Recent examples
– Japan late 1990’s
– India 2009
– UK 2009? If you consider RPI
Source: http://news.bbc.co.uk/2/hi/business/7955931.stm
How do we reduce inflation and avoid
deflation?
• Monetary Policy
– Interest rates
– Minimum reserve ration
– Quantitative easing
• Fiscal Policy
– Changes in spending
– Changes in taxation
• Supply-Side Policy
Controlling Inflation - FISCAL
TASK: Complete the diagram
Controlling Inflation - MONETARY
TASK: Complete the diagram
Controlling Inflation - SS
TASK: Complete the diagram