00Inflation Unit 26

Inflation
What is inflation?
The prices of goods and services are going up generally in the economy over a
period of time.
Ex – in 2016 the inflation rate in Peru was 3.2 percent. So prices rose on
average by 3.2 percent during the year.
Deflation
What is deflation?
Period where the level of aggregate demand is falling. (Fall in average price,
slowdown in the economy)
Aggregate Demand
Total demand in the economy including consumption, investment, government
expenditure, and exports minus imports.
AD = C + I + G + (X - M)
AD = Aggregate Demand
C = Consumption
I = Investment
G = Government expenditures
X = Total exports
M = Total imports

How to measure the Inflation?

Inflation is measured using the Consumer Price Index (CPI)
Every month, the government records the prices of about 600 goods and
services purchased by over 7000 families. This average price is then converted
into an index number.
Types of Inflation
1. Demand Pull Inflation
Demand pull inflation is when there is an increase in aggregate demand and
supply remains the same or decreases. When supply cannot meet growing
demand prices for goods and services are pulled higher.

Causes of Demand pull Inflation

 Rising consumer spending encouraged by tax cuts or low interest rates
 Sharp increases in government spending
 Rising demand for resources by firms
 Booming demand for exports

2. Cost Push Inflation

Inflation caused by rising business costs. Cost push inflation occurs when
overall prices rise due to increase in production costs such as wages and raw
materials.
Causes of Cost push Inflation
 Rising costs of imported goods
 Wage increases
 Increases in taxation

The relationship between inflation and interest rates

Interest rates – price paid to lenders for borrowed money. (Price of money)
Monetarists – Economists who believe there is a strong link between growth in
the money supply and inflation.
Money supply – the stock of notes and coins, bank deposits and other financial
assets in the economy.
When interest rates are low households, firms and the government borrow
more money from banks to fund extra spending. The extra money lent by the
banks creates more demand and prices are driven up.
If interest rates rise, borrowing will fall as it becomes more expensive, the
money supply will grow less quickly and demand will fall. As a result, the
pressure on prices is relieved so inflation will fall.

The impact of inflation

1. Prices – one of the main problems of inflation is that prices are rising.
Inflation reduces purchasing power of money. Then people cannot buy
as much with their income. If incomes are rising as fast, or faster than
prices, inflation not be a problem for individuals.

2. Wages – when prices are rising, workers need to increase their wages to
compensate for the loss in purchasing power. As a result of higher
wages, firms may need to raise their prices because costs have risen.
Pattern is repeated, a wages / prices spiral develops.

3. Exports – if inflation is higher than in other countries, firms may find it

difficult to sell in overseas markets. Falling demand for exports will also
result in job losses.

4. Unemployment – high level of inflation will caused to increase aggregate

demand. Then firms need to recruit more workers, which reduces
unemployment. If the government want to reduce inflation, it will have
to accept higher level of unemployment.

5. Menu cost – if inflation is rapid, firms will have to increase their prices
also. Ex- new brochures print, websites updated and sales staff informed
(restaurant new menu has to be printed)

6. Shoe leather costs – the costs that people incur to minimise their cash
holdings during time of high inflation. Consumers and firms will have to
 spend more time looking for the lowest prices or the best value for
money.

7. Uncertainty – inflation creates uncertainty, which makes planning for

the future very difficult. Making investment decisions are very difficult.
Another problem with uncertainty is linked to entering long term
contracts. Supplier cannot make price for contract if it does not know
what the inflation rate will be over this time?

8. Business and consumer confidence – inflation may have an effect on the

confidence of business and consumers. Inflation might make consumers
anxious. Consumers start to save money and demand will reduce.
Business also lose their confidence and they may postpone growth plans
or reduce their spending on product development.
Hyperinflation – very high level of inflation, rising prices get out of
control
9. Investment – inflation often result in a decline in business investment.
Uncertainty about future prices created by inflation, and lack lf business
confidence among decision makers, investment projects are likely to be
postponed or cancelled.