Slide-09-Price Stability & Inflation

BBM-ME-II
MODULE – A
Macroeconomic Objectives II:
Low & Stable Rate of Inflation
(Price Stability)
Prof. (Dr.) D N Panigrahi
PhD (Finance), MBA (Fin-FMS, DU), CFA & MS-Finance, CAIIB & DFS, M.Sc. (Physics)
INTRODUCTION
 This chapter is concerned with another one important macroeconomic

objective: low and stable rate of inflation, i.e., a gently rising price
level (or price stability).
LEARNING INTENTIONS
 In this chapter you will learn how to:

 • define the meaning of inflation, deflation and disinflation
 • calculate the rate of inflation
 • explain how changes in the price level are measured by the
 consumer price index
 • consider the difficulties of measuring changes in the price
 level
 • explain the difference between money values and real data
 • analyse the causes and types of inflation: cost-push and
 demand-pull inflation
 • analyse the consequences of inflation.
ECONOMICS IN CONTEXT:
Food queues lengthen in Venezuela
 At the end of 2018, many prices were doubling every nineteen days in
Venezuela. Each Venezuelan bolivar, the country’s currency, could
buy noticeably less than a day before. In 2016, the price of a cup of
coffee was 450 bolivars. By the end of 2018, it had risen to one
million bolivars.
 Over the same period, the time a teacher had to work to afford to buy
a chicken to eat rose from two hours to twenty days. In many cities,
including the capital city, Caracas, long queues formed at
supermarkets and, on a number of occasions, the supermarkets ran out
of food. Outside Caracas, some people were engaging in barter. For
example, in the markets of Cumana, some people were swapping fish
for cooking oil.
Fig. 20.1: A queue for food outside a supermarket in Venezuela
ECONOMICS IN CONTEXT:
Food queues lengthen in Venezuela
 Venezuela’s annual living conditions survey found that six out of ten
people said they went to bed hungry as they could not afford to buy
enough food. With wages rising by a much smaller percentage than
prices and unemployment rising, emigration from the country
increased. Two and a half million people, a seventh of the population,
left the country between 2014 and 2018.
 Discuss in a pair or a group:
 • Why is it useful to consider how long it takes to earn the money to
buy a product in assessing the impact of price rises?
 • Why do you think high price rises often result in long queues?
 • Why may people leave countries that are experiencing high price
rises?
What is Price Stability?
 Price stability occurs when prices rise by only a small percentage and
there is an avoidance of fluctuations in the price level. A low and
stable inflation rate can bring a number of advantages.
 This is why governments want their countries to experience price
stability. This objective is not always achieved.
 Some countries experience a high inflation rate with their price level
rising by a significant percentage. Others experience large fluctuations
in their price level.
 For example, their price level may have risen by 25% in one year,
40% in the next year and then 12% in the third year. At certain times,
some countries experience a fall in their price level.
What is Price Stability?
 KEY CONCEPT LINK: Progress and development: Price stability

can encourage firms to expand. Higher national output can create
employment, as well as increasing the goods and services available
for governments to spend on education and healthcare.
Low and Stable Rate of Inflation
 Inflation, disinflation and deflation: Distinguish between

inflation, disinflation and deflation.
 Inflation is defined as a sustained increase in the general price
level of the goods and services in an economy.
 When we speak of the ‘general price level’ we refer to an
average of prices of goods and services in the entire economy,
not to the price of any one particular good or service.
 ‘Sustained’ means that the general price level must increase to a
new level and not fall back again to its previous lower level.
 Further, an increase in the general price level does not

necessarily mean that prices of all goods and services are
increasing; prices of some goods and services may be
constant or even falling, while others are increasing.
 The presence of inflation indicates that prices of goods and
services are increasing on average.
 Explanation: Inflation does not mean that every price is
rising or that they are rising at the same rate.
 What inflation actually means is that, on average, prices are
rising at a particular rate.
 Explanation: For instance, an inflation rate of 6% would

mean that, on average, prices are 6% higher than in the
previous period.
 Some prices may rise by more and some may fall.
 When the price level (also known as the general price level)
increases, the value of money falls and its purchasing power
declines.
 Each unit of the currency, e.g. each dollar note, will buy less.
Degrees of Inflation
 A low and stable inflation rate, of for instance 2%, is not generally
regarded as a problem for an economy. A low and steady rise in prices
may even encourage firms to produce more. Such a rate of inflation is
sometimes known as creeping inflation.
 In contrast to a low rate of inflation is hyperinflation. Hyperinflation
is generally considered to be an inflation rate that exceeds 50% a
month, but the rate of inflation can go much higher.
 Hyperinflation occurs when inflation gets out of control and
sometimes results in people resorting to barter, exchanging goods and
services for other goods and services rather than using money to buy
and sell products.
Degrees of Inflation
 In such cases, the currency usually has to be replaced by a

new currency unit.
 At the start of the 21st century, Zimbabwe experienced an
inflation rate so high that economists had difficulty
measuring it. It has been estimated that in 2008 inflation in
Zimbabwe reached between 200 million per cent and 89
sextrillion per cent (Fig. 20.2).
Fig. 20.2: A ten-billion-dollar banknote from Zimbabwe
ACTIVITY 20.1
 In a group, prepare:
 • A wall chart showing your country’s inflation rate and another
two nearby countries’ (say, Pakistan and Bangladesh) inflation
rate over the last five years.
 • Another wall chart showing your predictions for your country’s
inflation rate over the next six months.
 Each month plot the actual rate against your prediction. (Note: a
number
 of international organisations, including the IMF and World
Bank, central banks and media organisations make inflation rate
predictions).
Deflation and Disinflation
 Deflation is defined as a sustained decrease (fall) in the general price

level of goods and services in an economy. As in the case of inflation,
deflation refers to an average of prices; it is likely to be uneven, with
some prices constant or even increasing.
 It results in a rise in the value of money, with each currency unit
having greater purchasing power. Deflation involves a negative
inflation rate, for example, –3%.
 Inflation is far more common than deflation; in fact, since the 1930s
(the period of the Great Depression in the US economy), most
economies around the world have been experiencing a rising price
level, or inflation.
 Students sometimes confuse the difference between changes in the

price level and changes in the rate of inflation.
 In our discussions of the AD-AS model, we have frequently seen
increases in the price level; these indicate inflation.
 A change in the rate of inflation, by contrast, refers to a change in
how fast the price level is rising. If the price level increases by 5% in
one year and then increases by 7% the next year, this represents an
increase in the rate of inflation.
 If the price level increases by 10% in one year and by 7% the next
year, this represents a decrease in the rate of inflation, and is called
disinflation. Disinflation therefore occurs when inflation occurs at a
lower rate.
 Explanation: Disinflation occurs when the inflation rate falls

but is still positive. For instance, the inflation rate may decline
from 8% to 6%. In this case, the price level is still rising but at a
slower rate. This is called disinflation.
 You must also be careful not to confuse a fall in the rate of
inflation, or disinflation, with a fall in the price level, or
deflation.
 A fall in the rate of inflation, such as from 10% to 7%, means that
the price level is increasing at a lower rate, hence is disinflation.
 A fall in the price level indicates that deflation is occurring.
ACTIVITY 20.2
 Fig. 20.3 shows the inflation rates of Indonesia, Japan, Malaysia, the
Philippines and Thailand between 2016 and 2019.
 In pairs, using Fig. 20.3, discuss:
 1 What happened to the price level in Thailand between 2018 and
2019?
 2 Which countries experienced disinflation between 2016 and 2017?
 3 Is it possible to determine from the graph whether prices were
higher in the Philippines than in Japan in 2019? Explain your answer.
 Then check whether your answers agree with the rest of the group.
Fig. 20.3: Percentage Change in Consumer Price Index
in Selected Countries, 2016–2019
Calculating the Inflation Rate
 The inflation rate is the percentage change in the price level from one period to
another. The percentage change can be the change in average prices from one
month to the next month, or from one quarter to the next quarter of the year, or
from one year to the next year.
 The two comparisons most used by economists are the annual average
method and the year-on-year method.
 • The annual average method compares the average level of prices during a
twelve-month period, for example 2021 with the average level in the previous
twelve months, 2020.
 • The year-on-year method is calculated as the percentage change in the price
level for a given month with that of the same month of the previous year. For
instance, if the price level rose from 120 in June 2021 to 126 in June 2022, the
inflation rate would be: (126 – 120)/120 × 100 = 6/120 x 100 = 5%.
ACTIVITY 20.3
 Table 20.1 below shows the consumer price index for
Bangladesh from 2012–2018.
 Using Table 20.1:
 1 Calculate Bangladesh’s inflation rate for each year from
2013 to 2018.
 2 In which year was the inflation rate highest?
 3 In which year was the price level highest?
 Compare your answers with another learner.
Table 20.1: Bangladesh Consumer Price Index, 2012–18
Year CPI
2012 118
2013 127
2014 136
2015 145
2016 153
2017 161
2018 170
Measuring Inflation and Deflation:
The Consumer Price Index
 Explain that inflation and deflation are typically measured by
calculating a consumer price index (CPI), which measures the
change in prices of a basket of goods and services consumed by the
average household.
 Measures of inflation (and deflation) are obtained by use of price
indices (indices is the plural of index). A price index is a measure of
average prices in one period relative to average prices in a reference
period called a base period. One of the most commonly used price
indices to measure inflation is the consumer price index (CPI).
 A country’s price level indicates how much it costs to live in that
country. A rise in the price level means that the cost of living has
increased.
 The consumer price index (CPI) is a measure of the cost of living, or
the cost of goods and services purchased by the typical household in
an economy. It is constructed by a statistical service in each country,
which creates a hypothetical ‘basket’ containing thousands of goods
and services that are consumed by the typical household in the course
of a year.
 The value of this basket is calculated for a particular year (called a
base year); this is done by multiplying price times quantity for each
good and service in the basket, and adding up to obtain the total value
of the basket.
 The value of the same basket of goods and services is then calculated
for subsequent years.
 The result is a series of numbers that show the value of the same
basket of goods and services for different years.
 The CPI is then constructed to show how the value of the basket
changes from year to year by comparing its value with the base year.
 Once the consumer price index is constructed, inflation and deflation
can be expressed as a percentage change of the index from one year to
the other, which is simply a measure of the percentage change in the
value of the basket from one year to another.
 Since the value of the basket changes from one period to another
because of changes in the prices of the goods in the basket, these
percentage changes reflect changes in the average price level.
 A rising price index indicates inflation; a falling price index indicates
deflation.
 CPIs and rates of change in the price level are also calculated on a
monthly basis and a quarterly basis.
 Summary: The consumer price index (CPI) is a measure of the cost
of living for the typical household, and compares the value of a basket
of goods and services in one year with the value of the same basket in
a base year.
 Inflation (and deflation) are measured as a percentage change in the
value of the basket from one year to another.
 A positive percentage change indicates inflation. A negative
percentage change indicates deflation.
Construction of Consumer Price Index (CPI)
 To assess changes in the cost of living, governments

construct a consumer price index (CPI). There are a
number of stages in constructing a CPI, as shown in Fig. 20.4
below.
 Table 20.2 shows an adaptation of how the consumer price
index for Mauritius for August 2019 was calculated.
 From August 2018 to August 2019 the Mauritian price level
rose by 1.8%.
 That is, Mauritius experienced an inflation rate of 1.8% in
the year between August 2018 to August 2019.
Fig. 20.4: How Governments Construct
a Consumer Price Index (CPI)
Table 20.2: Consumer Price Index August 2019
(Year-on-Year), Mauritius
Category Weight % % Price Weighted Price
(w) Change (p) Change (w x p)
Food and beverages 24.8 5.8 (0.058) 1.44
Tobacco 11 1.6 (0.016) 0.18
Clothing and footwear 4.6 3.4 (0.034) 0.16
Housing, water, electricity, gas 11.2 -0.5 (0.005) -0.06
and other fuels
Furnishings, household 5.9 2.2 (0.022) 0.13
equipment and routine
household maintenance
Health 3.8 2.1 (0.021) 0.08
Table 20.2: Consumer Price Index August 2019
(Year-on-Year), Mauritius
Category Weight % % Price Weighted Price
(w) Change (p) Change (w x p)
Transport 14.7 -1.2 (0.012) -0.18
Communications 4.4 -1.0 (0.01) -0.05
Recreation and culture 4.2 -4.0 (0.04) -0.17
Education 5 1.0 (0.01) 0.05
Restaurants and hotels 5.4 3.0 (0.03) 0.16
Miscellaneous goods and 5 1.2 (0.012) 0.06
services
All items 100 --- 1.80
ACTIVITY 20.4
 In a group, assume that you have been given $200. You have to
spend all of this money. Decide what proportion you would
spend on food, on clothing, on entertainment and on other items
(miscellaneous).
 On the basis of your decisions, attach weights to the four
categories.
 Then, assuming that the price of food has risen by 10%, the price
of clothing has risen by 20%, the price of entertainment has
fallen by 5% and the price of other items has risen by 2.5%,
calculate the inflation rate you would experience.
Problems with the Consumer Price Index (CPI)
 Explain that different income earners may experience a different rate of
inflation when their pattern of consumption is not accurately reflected by the
CPI.
 Explain that inflation figures may not accurately reflect changes in
consumption patterns and the quality of the products purchased.
 The CPI, we have seen, is based on a fixed basket of goods and services defined
for a particular year, meant to reflect purchases of consumer goods and services
by the typical household. The use of such a basket leads to some problems:
 • Different rates of inflation for different income earners. The rate of inflation
calculated by use of the CPI reflects the change in average prices of goods and
services included in the basket. However, different consumers have different
consumption patterns depending on their income levels, and these may differ
from what is included in the basket. This means they face different rates of
inflation than what is calculated on the basis of the CPI basket.
 • Different rates of inflation depending on regional or cultural factors.
Exactly the same idea as above applies to consumer groups whose purchases
differ from the typical household’s consumption patterns, because of variations in
tastes due to cultural and regional factors.
 • Changes in consumption patterns due to consumer substitutions when
relative prices change. Each good and service included in the basket is weighted
(multiplied by the number of units of the good or service purchased by the typical
household over a year). However, as some goods and services become cheaper or
more expensive over time, consumers make substitutions, buying more units of
the cheaper goods and less of the more expensive ones. This results in changing
weights (number of units consumed by the typical household), but because the
weights in the basket are fixed, the changes in consumption patterns cannot be
accounted for in the CPI. Therefore, the CPI gives a misleading impression of the
degree of inflation, usually overstating it.
 • Changes in consumption patterns due to increasing use of discount stores
and sales. In many countries, consumers increasingly make use of discount stores
and sales, thus buying some goods and services at lower prices than those used in
CPI calculations. This is another reason why the CPI tends to overstate inflation.
 • Changes in consumption patterns due to introduction of new products. In
this case, too, a fixed basket of goods and services cannot account for new
products introduced into the market, as well as older products that become less
popular or are withdrawn (consider for example the replacement of videotapes by
DVDs).
 • Changes in product quality. This is another problem related to the use of a
fixed basket of goods and services. The CPI cannot account for quality changes
over time.
 • International comparisons. The CPIs of different countries differ from each
other with respect to the types of goods and services included in the basket, the
weights used and methods of calculation. This limits the comparability of CPIs
and inflation rates from country to country. To address this problem, the European
Union (EU) has devised a Harmonised Index of Consumer Prices (HICP). The
HICP determines consistent and compatible rules that must be followed by EU
countries in order to calculate CPIs that are consistent with each other.
 • Comparability over time. Virtually all countries around the world periodically
revise their CPI baskets and change the base year (usually about every ten years)
to try to deal with many of the problems noted above. In many countries the
weights of goods and services are changed as often as every year. This means that
whereas price index numbers are comparable over short periods of time, over
longer periods comparability is lessened because of cumulative changes in the
basket of goods and services.
The Core Rate of Inflation
 Explain that economists measure a core/underlying rate of inflation

to eliminate the effect of sudden swings in the prices of food and oil,
for example.
 There are certain goods, notably food and energy products (such as
oil) that have highly volatile prices (meaning they fluctuate widely
over short periods of time). Reasons for price volatility include wide
swings in supply or demand, causing large and abrupt price changes.
When such goods are included in the CPI, they may give rise to
misleading impressions regarding the rate of inflation.
 To deal with this problem, economists measure a core rate of inflation,
which usually is done by constructing a CPI that does not include
food and energy products with highly volatile prices.
The Producer Price Index (PPI)
 Explain that a producer price index measuring changes in the

prices of factors of production may be useful in predicting future
inflation.
 The producer price index (PPI) is actually several indices of prices
received by producers of goods at various stages in the production
process.
 For example, there is a PPI for inputs, a PPI for intermediate goods
and a PPI for final goods (at the wholesale level, not retail).
 PPIs measure price level changes from the point of view of producers
rather than consumers.
The Producer Price Index (PPI)
 Price level changes measured by PPIs are considered to be predictors

of changes in the consumer price index (CPI) and hence predictors of
the rate of inflation, because they measure price changes at an earlier
stage in the production process.
 For example, if prices of inputs or intermediate prices are rising, it is
likely that the prices of the final products paid by consumers will also
rise at a later date.
 Also, if wholesale prices are rising, that also indicates that the higher
prices will eventually be passed on to consumers.
Test Your Understanding 10.3
 1 (a) Distinguish between inflation, deflation and disinflation, and provide

numerical examples illustrating each of these.
 (b) Explain, using examples, the difference between an increase in the price
level and an increase in the rate of inflation.
 2 (a) Describe the meaning of the consumer price index (CPI) and explain
the purpose for which it is constructed.
 (b) Why does the CPI fail to present an accurate picture of the rate of
inflation for all consumer groups?
 3 (a) Distinguish between the consumer price index (CPI) and the producer
price index (PPI).
 (b) Why can the PPI be useful for predicting changes in the CPI?
 4 Describe the meaning of a core rate of inflation and how this is
calculated.
Difference b/w Money (Nominal) Values and Real Values
 Money values, or nominal values, are the values of the prices

operating at the time (i.e., values at current prices which includes the
effect of inflation).
 In contrast, real data (values) is data in real terms ((i.e., values at
constant prices which removes the effect of inflation). In other words,
real data has been adjusted for inflation.
 Nominal Values –Vs- Real Values: Nominal values measure the
quantity of money whereas real values measure the purchasing power.
 How to Convert Nominal to Real Values: To convert money values
into real data, the figures are multiplied by the price index in the base
year and divided by the price index in the current year [i.e., deflate the
nominal data).
 Calculating Real Income: For example, a worker’s wages may rise

from $5,000 in 2015 to $6,000 in 2016. The worker may think they
have received a 20% pay rise. The worker will have this rise of 20%
in money terms but not in real terms (which measures purchasing
power) if inflation has occurred. If the consumer price index was 100
in 2015 and 125 in 2016, the worker’s wages in real terms would have
changed to: $6,000 × (100/125) = $4,800.
 So, in real terms, the worker’s income has fallen by 4%. With an
inflation rate of 25%, a 20% pay rise will mean that the worker will be
able to buy fewer goods and services.
 Changes in real data can be roughly estimated by deducting the
change in the inflation rate from the change in the money value.
 For instance, if the money interest rate (sometimes known as the

nominal interest rate) is 5% and the inflation rate is 6%, the real rate
of interest is –1%.
 Clearly, if nominal income increases by the same percentage as the
change in price level or inflation rate (measured by the CPI), real
income remains unchanged.
 The CPI or inflation rate is, in fact, very useful for calculating
adjustments that must be made to nominal income (of wage-earners,
pensioners, etc.) in order for these groups to maintain a constant or
increasing real income in order to protect or increase their purchasing
power.
ACTIVITY 20.6
 Calculate the change in real wages for the countries shown in

Table 20.3.
 Compare your results with another learner.
Table 20.3: Change in Money Wages 2018
Country Change in Money Wages (%) Inflation Rate (%)
Belarus 13.5 4.9
Estonia 7.4 3.5
Russia 3.0 2.9
Serbia 9.0 2.0
Ukraine 17.4 9.9

Types and Causes of Inflation
 There are two main causes of inflation: demand-pull inflation and

cost-push inflation.
 Demand-pull inflation: Explain, using a diagram, that demand-pull
inflation is caused by changes in the determinants of AD, resulting
in an increase in AD.
 Demand-pull inflation is caused by increases in aggregate demand, in
turn brought about by changes in any of the determinants of aggregate
demand (see Chapter/Slide 6 on AD-AS).
 Assume the economy is initially at full employment equilibrium,
producing potential GDP, shown as Yp in Fig. 10.4 parts (a) and (b)
below.
Fig. 10.4: Demand-pull Inflation
Types and Causes of Inflation: Demand-pull Inflation
 The economy experiences an increase in aggregate demand appearing

as a rightward shift of the AD curve from AD1 to AD2 in both
diagrams.
 The impact on the economy is to increase the price level from Pl1 to
Pl2, and to increase the equilibrium level of real GDP from Yp to
Yinfl. The increase in the price level from Pl1 to Pl2 due to the
increase in aggregate demand is known as demand-pull inflation.
 Note that demand-pull inflation is associated with an inflationary gap:
real GDP is greater than full employment GDP, and unemployment
falls to a level below the natural rate of unemployment. The demand
for labour is so large that some workers who are structurally,
frictionally or seasonally unemployed temporarily find jobs.
Demand-pull Inflation: Summary
 Demand-pull inflation involves an excess of aggregate demand over

aggregate supply at the full employment level of output, and is caused
by an increase in aggregate demand. It is shown in the AD-AS model
as a rightward shift in the AD curve.
 Demand-pull inflation occurs when prices are ‘pulled up’ by increases
in aggregate demand that are not matched by equivalent increases in
aggregate supply.
 Any of the components of aggregate demand may increase. So
demand-pull inflation may result from a rise in consumer expenditure,
government spending, investment or a rise in net exports.
 Fig. 20.6 below (in a simple alternative way) shows that an increase in
aggregate demand has caused a rise in the price level from P to P1.
Fig. 20.6: Demand-pull inflation
 A rise in aggregate demand will have a greater impact on the price

level the closer the economy comes to full capacity.
 An increase in some forms of government spending and investment
may not be inflationary in the long run. This is because, for example,
government spending on education and healthcare may raise labour
productivity and so increase productive capacity of the economy.
 Increases in aggregate demand may result from, for instance, a
consumer boom, a rise in government spending, higher business
confidence resulting in an increase in investment or an increase in net
exports.
 Monetarists argue that the key cause of higher aggregate demand is

increases in the money supply. They suggest that if the money supply
grows more rapidly than output (i.e., too much money chasing too few
goods), the greater supply of money will drive up the price level.
Some economists view ‘monetary inflation’ as a specific cause of
inflation.
 While all economists accept that there is a clear link between changes
in the money supply and changes in the price level, there is a debate
as to which causes which. Keynesians argue that it is inflation that
causes an increase in the money supply and not the other way around.
If costs rise, firms may borrow more from banks. This will cause an
increase in the quantity of money.
Types and Causes of Inflation: Cost-push Inflation
 Cost-push inflation: Explain, using a diagram, that cost-push

inflation is caused by an increase in the costs of factors of
production, resulting in a decrease in SRAS.
 Cost-push inflation is caused by increases in costs of production or
supply-side shocks. Assume the economy is initially at the full
employment level of output, Yp in Fig. 10.5 below, and suppose there
is an increase in costs of production. The SRAS curve shifts from
SRAS1 to SRAS2, leading to an increase in the price level from Pl1 to
Pl2, and a fall in the equilibrium level of real GDP from Yp to Yrec.
 The increase in the price level due to the fall in SRAS is known as
cost-push inflation.
Fig. 10.5: Cost-push Inflation
 Cost-push inflation is analysed only by means of the monetarist/new

classical AD-AS model. The Keynesian model is not equipped to deal
with short-term fluctuations of aggregate supply.
 Keynes was concerned with showing the importance of aggregate
demand in causing short-term fluctuations. The output level Yrec,
though indicating a recession, is not called a recessionary or
deflationary gap, because output gaps (whether recessionary or
inflationary) can only be caused by too little or too much aggregate
demand.
 In Chapter/Slide 6 on AD-AS, we saw that a decrease in SRAS poses

a special set of problems because it leads to both inflation and a fall in
real GDP (with more unemployment).
 The presence of both inflation and unemployment (fall in real GDP) is
called stagflation, a combination of the words ‘stagnation’ and
‘inflation’.
 This should be contrasted with an increase in aggregate demand
leading to demand-pull inflation, which results in a higher price level
(inflation) but an increase in real GDP (with less unemployment).
 Cost-push inflation is more difficult to deal with effectively, as we
will discover in Chapter/Slide on Economic Policies.
Cost-push Inflation: Summary
 Cost-push inflation is caused by a fall in aggregate supply, in turn

resulting from increases in wages or prices of other inputs, shown in
the AD-AS model as leftward shifts of the AS curve.
 Cost-push inflation occurs when prices are pushed up by increases in
the cost of production.
 Fig. 20.5 below (in a simpler alternative way) shows that a decrease in
aggregate supply caused by higher costs of production pushes up the
price level, causes a contraction in aggregate demand and reduces real
GDP.
 There are a number of costs that may rise. For instance, wages may
increase more than labour productivity and so result in a rise in labour
costs.
Fig. 20.5: Cost-push Inflation
 Higher wages can cause a wage–price (cost) spiral. Workers gain a

wage rise, which causes prices to increase, then workers seek higher
wages to restore their real value and so on.
 Increases in raw material costs and fuel can also push up prices.
 In some cases, these increases may be caused by a fall in the exchange
rate.
 For example, if the value of the Indian rupee falls, the price of oil
imported into the country will rise. This, in turn, will result in higher
transport and production costs, which will lead to higher prices.
 An increase in firms’ profit margins will also increase costs of

production.
 In addition, costs may be pushed up by damage to or depletion of
resources. For example, a period of bad weather may reduce the
fertility of land and supplies of oil may be reduced.
The link b/w Demand-pull Inflation and
Cost-push Inflation
 Some changes will both increase aggregate demand and increase costs of
production. For example, a fall in a country’s foreign exchange rate may
both raise the price of imported raw materials (cost-push inflation) and
increase export revenue (demand-pull inflation).
 Also, once inflation occurs, there is a risk that an inflationary spiral may
occur. Demand-pull and cost-push factors may interact and reinforce each
other and an inflationary spiral may develop.
 Higher government spending on state pensions, for instance, may increase
aggregate demand. The resulting higher prices may encourage workers to
call for higher wages. If they do gain higher wages, costs of production
may increase, causing aggregate supply to decrease. The higher wages may
increase consumer expenditure and so the upward pressure on prices would
continue.
The link b/w Demand-pull Inflation and
Cost-push Inflation
 TIP: In explaining the difference between cost-push and demand-pull
inflation, it is useful to include AD/AS diagrams.
 These can clearly show that cost-push inflation is linked to decreases in
aggregate supply whereas demand-pull inflation is linked to increases in
aggregate demand.
Real World Focus:
Rate of Inflation Slows in Thailand
 The consumer price index in Thailand rose by 3% in April from the
year before, compared to 3.7% in February and 4.1% in January. The
core inflation rate, which excludes food and energy costs, increased
by 0.5% year-on-year.
 The producer price index, based on 506 products, showed a much
higher increase, of 8.5%. This reflected increases in agricultural,
mining and industrial costs.
 The falling rate of inflation reflects consumer caution in spending,
which is due to political trouble. It is believed that the current
inflation has cost-push causes, arising from higher oil and other
input prices, rather than demand-pull causes, stemming from greater
demand.
Real World Focus:
Rate of Inflation Slows in Thailand
 Applying your skills:
 1 Explain the meaning and use of the (a) consumer price index (CPI),
(b) producer price index (PPI), and (c) core inflation rate.
 2 Explain whether the slowdown in Thailand’s rate of inflation
represents deflation or disinflation.
 3 What does Thailand’s PPI predict about its future CPI?
 4 (a) Using diagrams, explain the difference between cost-push and
demand-pull inflation.
 (b) Why is it believed that current inflation in Thailand is due to cost-
push rather than demand-pull factors?
 Source: ‘April Consumer Price Index rises 3% year-on-year’ in
Thai Press Reports, 5 May 2010.
ACTIVITY 20.7
 Argentina’s inflation rate reached 47.6% in 2018, its highest rate since
1991, when the inflation rate was 84%.
 The value of its currency, the peso, fell by 50% against the dollar and
the country’s output fell by 1%.
 In August 2018, the country’s central bank raised the rate of interest to
60%, one of the highest interest rates in the world.
 In a group, decide:
 1 whether Argentina was more likely to have experienced cost-push or
demand-pull inflation in 2018
 2 whether Argentinian consumers would have been likely to have
spent more or less in 2018.
ACTIVITY 20.7
 3 What other information might have been useful in helping you

decide?
 TIP: Remember that once there is evidence of inflation, it is difficult
to determine its cause. For instance, wages and consumer expenditure
may be increasing but it may be difficult to know which occurred first
and so whether inflation is the result of demand-pull or cost-push
factors.
 KEY CONCEPT LINK: Equilibrium and disequilibrium: If
increases in AS can keep pace with increases in AD, the economy can
move to new macroeconomic equilibriums without any inflationary
pressure.
Evaluating Govt. Policies to Address
the Different Types of Inflation
 Evaluate government policies to deal with the different types of
inflation.
 Government policies to deal with the different types of inflation will
be studied and evaluated in Chapter/Slide on Economic Policies.
 As in the case of different types of unemployment, each of which has
its own set of appropriate policies, so in the case of inflation, demand-
pull and cost-push inflation must be addressed by the use of different
kinds of policies.
 We will evaluate the various policies to deal with inflation in Chapter/
Slide on Economic Policies.
Test your understanding 10.5
 1 Using appropriate diagrams, explain the difference between demand-pull

and cost-push inflation.
 2 Why is cost-push inflation potentially more serious than demand-pull
inflation?
 3 Using diagrams, show the effects on the price level of the following
events, and explain whether it is cost-push or demand-pull inflation:
 (a) Real GDP in foreign countries that trade with your country increases,
leading to increased demand for your country’s exports.
 (b) Businesses are optimistic that a recession is about to end, and so
increase investment spending.
 (c) An increase in housing prices makes consumers increase their
consumption expenditures.
 (d) A sudden increase in the price of oil, a key input in production, occurs.
Consequences of Inflation
 Inflation has both possible costs and potential benefits.

 Inflation, and especially a high rate of inflation, poses problems for an
economy, because it affects particular population groups especially
strongly, as well as the economy as a whole.
 The relationship between inflation, purchasing power and nominal
income and real income: To understand why problems can arise, let’s
consider the relationship between inflation and purchasing power, and
nominal income and real income.
 Purchasing power refers to the quantity of goods and services that can
be bought with money. Imagine you have £60 to spend on shirts. You
can think of this as your ‘nominal income’. When the price is £20 per
shirt, you can buy three shirts.
 If the price increases to £30 per shirt, you can only buy two shirts.
 Your money, or your nominal income of £60 has not changed, yet the
purchasing power of the £60, or what this money can buy, has fallen
due to the increase in price.
 ‘Real income’ is the same as ‘purchasing power’; it refers to what
your money can buy: it decreases as prices rise, and increases as
prices fall.
 Changes in real income, nominal (money) income and the general
price level are related to each other in the following way (roughly):
 % change in real income (or purchasing power) = % change in
nominal income − % change in the price level (or the rate of
inflation)
 These relationships illustrate some important points. Inflation leads to

a fall in real income, or purchasing power, only if nominal income is
constant, or if nominal income increases more slowly than the price
level (inflation rate).
 Say there is a 5% increase in the price level, which is a 5% rate of
inflation. How will your real income be affected?
 If your nominal income also increases by 5% (or more), your real
income, or purchasing power, remains unchanged (or increases).
Therefore, for you, inflation is not a problem.
 If, however, your nominal income remains constant or increases by
less than 5%, your real income falls, and you will be worse off since
the purchasing power of your income is reduced.
Consequences of Inflation: Possible Costs
 Discuss the possible consequences of a high inflation rate, including

greater uncertainty, redistributive effects, less saving, and the damage to
export competitiveness.
 Redistribution effects: Inflation redistributes income away from certain
groups in the economy and towards other groups. Redistribution arises in
situations where certain groups lose some purchasing power and become
worse off, while other groups gain purchasing power and become better
off. Groups who lose from inflation include:
 • People who receive fixed incomes or wages. When individuals receive
an income or wage that is fixed or constant, as the general price level
increases they become worse off.
 • People who receive fixed incomes or wages (Contd…).

 This occurs when:
 workers have wage contracts fixing their wages over a period of time
 pensioners receive fixed pensions
 landlords receive fixed rental income
 individuals receive fixed welfare payments.
 • People who receive incomes or wages that increase less rapidly than
the rate of inflation. When individuals’ incomes do not keep up with a
rising price level (do not increase as fast as the price level or inflation rate),
a fall in their real incomes results and they therefore become worse off.
These groups may include all those noted above plus any other kind of
income receiver whose income is not increasing as rapidly as the price
level.
 • Holders of cash. As the price level increases, the real value or purchasing
power of any cash or liquid asset (cash like) held falls.
 • Savers. People who save money may become worse off as a result of
inflation. In order to maintain/protect the real value (purchasing power) of
their savings, savers must receive a rate of interest that is at least equal to
the rate of inflation.
 Suppose you deposit $1,000 in a bank account that pays you no interest. If
there is inflation, the real value of your savings will fall.
 However, you may be able to protect the purchasing power of your savings.
Say the rate of inflation is 5% per year. If you receive interest on your
deposit at the rate of 5% per year, what you will lose through inflation will
be exactly matched by what you gain through interest income. In this case,
the real value (or purchasing power) of your savings remains unaffected.
 In general, savers who receive a rate of interest on their savings lower than
the rate of inflation suffer a fall in the real value (or purchasing power) of
their savings.
 • Lenders (creditors). People (or financial institutions such as banks) who
lend money may be worse off due to inflation. Assume you lend your
friend €100 for one year (and you do not charge interest). If in the course of
the year there is an increase in the price level (inflation), the real value of
the €100 you will get back from your friend at the end of the year will have
fallen.
 If you charged your friend a rate of interest equal to the rate of inflation,
then the real value of your loan to your friend will be exactly maintained.
 In general, lending at a lower interest rate than the rate of inflation makes
the lender (creditor) worse off at the end of the loan period.
Potential Benefits of Inflation
 Groups who gain from inflation include:

 • Borrowers (debtors). In the example above, your friend who
borrowed €100 from you benefits since the €100 paid back after one
year is worth less than one year ago. If you had charged interest, your
friend (the borrower) would benefit as long as the rate of interest is
lower than the rate of inflation.
 In general, borrowing at a lower interest rate than the rate of inflation
makes the borrower (debtor) better off at the end of the loan period.
Potential Benefits of Inflation
 Groups who gain from inflation include (Contd…):

 • Payers of fixed incomes or wages. As long as nominal wages,
pensions, rents, welfare payments, etc., are fixed while there is
inflation, the payers (whether they are firms, the government, payers
of rent, etc.) benefit as the real value of their payments falls due to
inflation.
 • Payers of incomes or wages that increase less rapidly than the
rate of inflation. As long as incomes of any kind increase less rapidly
than the rate of inflation, the payers of these incomes benefit due to
the falling real value of their payments.
 Uncertainty: Inability to accurately predict what inflation will be in the

future means that people cannot predict future changes in purchasing power
(of income, wealth, loans and anything else that is measured in terms of
money).
 This causes uncertainty among economic decisionmakers. Firms, in
particular, become more cautious about making future plans under
uncertainty about future price levels, because they are unable to make
accurate forecasts of costs and revenues, as these depend on the future
prices of their inputs and their products.
 Their uncertainty leads them to make fewer investments, which in turn may
lead to lower economic growth.
 Menu costs: Menu costs are costs incurred by firms when they have to
print new menus (in restaurants), catalogues, advertisements, price labels,
etc., due to changes in prices. The higher the rate of inflation, the more
often firms have to change their prices and therefore, the higher the menu
costs.
 Money illusion: Money illusion refers to the idea that some people feel
better off when their nominal income increases, even though the price level
may increase at the same rate and possibly even faster. When this occurs,
people are under the illusion that they are better off whereas in fact they are
not: their real income or purchasing power has not changed at all, and may
even have decreased. If money illusion is widespread, it has negative
consequences because it leads consumers to make wrong spending
decisions.
 International (export) competitiveness: When the price level in a country

increases more rapidly than the price level in other countries with which it
trades, its exports become more expensive to foreign buyers, while imports
become cheaper to domestic buyers. The country’s international
competitiveness, or its ability to compete with foreign countries, is reduced.
The result is that the quantity of exports falls, and the quantity of imports
increases. This in turn may create difficulties for the country’s balance of
payments.
Factors Affecting the Consequences of Inflation
 The effects of inflation depend on:

 • The cause of inflation. Demand-pull inflation is likely to be less harmful than
cost-push inflation. This is because demand-pull inflation is associated with rising
output (and falling unemployment) whereas cost-push inflation is associated with
falling output (and rising unemployment).
 • The rate of inflation. A high rate of inflation is likely to cause more damage
than a low rate especially if the high rate develops into hyperinflation. Indeed,
hyperinflation can lead to households and firms losing faith in the currency and
may bring down a government.
 • Whether the rate of inflation is accelerating or stable. An accelerating
inflation rate, and even a fluctuating (constantly changing) inflation rate, will
cause uncertainty and may discourage firms from investing. The need to devote
more time and effort to estimating future inflation rates will increase costs.
Factors Affecting the Consequences of Inflation
 • Whether the inflation rate is the one that has been expected. Unanticipated
inflation, which occurs when the inflation rate was different from that expected,
can also create uncertainty and so can discourage some consumer expenditure and
investment. In contrast, if households, firms and the government have correctly
anticipated inflation, they can take measures to adapt to it and so avoid some of
its potentially harmful effects. For instance, firms may have adjusted their prices,
money interest rates may have been changed to maintain real interest rates and
the government may have adjusted tax brackets, raised pensions and public sector
wages in line with inflation.
 • How the inflation rate compares with the rate of other countries. It is
possible for a country to have a relatively high rate of inflation, but if it is below
that of competing countries its products may become more internationally
competitive.
What is an Appropriate Rate of Inflation?
 Most governments prefer a low and stable rate of inflation, not a zero
rate of inflation.
 Why is a zero rate of inflation, meaning a constant price level, not
the preferred objective?
 The reason is that a zero rate of inflation comes dangerously close to
deflation, which as we will see below can cause serious problems for
an economy.
 There is no one particular rate of inflation that is ideal, but many
governments would like to see this in the range of about 2–3% per
year. Less than 2% might be considered as coming close to deflation;
more than 4% is seen as being too high.
 1 Using a numerical example, explain the relationship

between inflation and purchasing power.
 2 Explain what happens to your real income (purchasing
power) in each of the following situations:
 (a) your nominal income increases by 5% and the rate of
inflation is 8%,
 (b) your nominal income falls by 10%, and the rate of
inflation is 3%, and
 (c) your nominal income increases by 7% and the rate of
inflation is 7%.
 3 (a) Inflation results in redistribution of purchasing power.

Explain who is likely to gain and who is likely to lose from
the redistribution effects of inflation.
 (b) What are some other negative consequences of inflation
(other than redistribution)?
THINK LIKE AN ECONOMIST:
The effects of hyperinflation
 Research a country that has experienced hyperinflation.
Produce a report on why such a high rate of inflation is likely
to be very harmful.
 What sources did you use for the basis of your report?
 Did you provide examples from the country’s experience to
illustrate your points?
 TIP: Remember that inflation does not always reduce the
purchasing power of households. It does, ceteris paribus or
other things equal, but if wages rise by more than prices,
households will be able to purchase more goods and
services.
Fig. 20.8: High denomination banknotes that were issued in
2008 due to extreme hyperinflation in Zimbabwe
Consequences and Causes of Deflation
 Why deflation occurs rarely in the real world: Deflation is not a common
phenomenon. Whereas it is often the case that the price of a particular good or
service may fall over time, it is rare to see the general price level of an economy
falling. There are several factors that account for this:
 • Wages of workers do not ordinarily fall. This means it is difficult for firms to
lower the prices of their products, as this would cut into their profits, especially
since wages represent a large proportion of firms’ costs of production. There are
several reasons why wages do not fall easily (labour contracts, minimum wage
legislation, worker and union resistance to wage cuts, ideas of fairness, fears of
negative impacts on workers’ morale, etc.).
 • Large oligopolistic firms may fear price wars. If one firm lowers its price,
then others may lower theirs more aggressively in an effort to capture market
shares, and then all the firms will be worse off. Therefore, firms avoid cutting
their prices.
Consequences and Causes of Deflation
 • Firms want to avoid incurring menu costs resulting from price changes,
particularly if they believe that the lower prices will prevail only for short periods
of time. Therefore, they avoid lowering their prices.
 Whereas deflation occurs rarely, it has appeared periodically, for example in
Britain and the United States in the late 19th century, in the United States during
the depression of the 1930s (1933–7), and in Japan from 1999 to 2006. In 2003
and again in 2008, there were serious concerns in Europe and the United States
that deflation might occur.
 Deflation is generally feared more than inflation, because it may pose potentially
serious problems for an economy.
 The negative consequences of deflation are discussed below.
Consequences of Deflation
 Discuss the possible consequences of deflation, including high

levels of cyclical unemployment and bankruptcies.
 Redistribution effects: The redistribution effects of deflation are the
opposite of those of inflation: with a falling price level, individuals on
fixed incomes, holders of cash, savers and lenders (creditors) all gain
as the real value of their income or holdings increases.
 By contrast, borrowers (debtors) and payers of individuals with fixed
incomes lose with a falling price level, as they must pay out sums that
have an increasing real value.
 Uncertainty: Deflation, like inflation, creates uncertainty for firms,
which are unable to forecast their costs and revenues due to declining
price levels.
 Menu costs: Menu costs (the costs to firms of printing new menus,
catalogues, advertisements, price labels, etc.) are similar in the case of
deflation as in the case of inflation, as both simply involve changes in
prices.
 Risk of a deflationary spiral with high and increasing cyclical
unemployment: A deflationary spiral involves a process where deflation
sets into motion a series of events that worsen the deflation.
 Deflation discourages spending by consumers, because they postpone
making purchases as they expect that prices will continue to fall.
 Deflation also discourages borrowing by both consumers and firms, for the
reason noted above: the real value of debt increases as the price level falls.
The result is that consumer and business spending falls, causing aggregate
demand to fall.
 If the economy is already in recession, this will become deeper with falling
AD, unemployment increases further, incomes and prices fall further,
deflationary pressures increase further, spending and borrowing decrease
further, and so on in a downward spiral.
 Risk of bankruptcies and a financial crisis: As we saw above, deflation
results in an increase in the real value of debt. If the economy is in
recession, and incomes are falling while the real value of debt is increasing,
the result will most likely be bankruptcies of firms and consumers who are
unable to pay back their debts. If such bankruptcies become widespread,
banks and financial institutions will be affected, and a large risk of a major
financial crisis arises.
 The last two items, risks of a deflationary spiral and a financial crisis,
reveal the special and potentially serious dangers of deflation.
Causes of Deflation: Bad and Good Deflation
 From an analytical point of view, we can make a distinction between

two causes of deflation: decreases in aggregate demand, held to
lead to a ‘bad’ kind of deflation, and increases in aggregate supply,
held to lead to ‘good’ deflation.
 Bad Deflation: A bad deflation takes place when the price level is
driven down by a fall in aggregate demand (AD) as shown in Fig.
20.10 below.
 To see how ‘bad’ deflation could arise, suppose the economy is at a
point of long run equilibrium as in Fig. 20.10 below, and assume there
is a decrease in aggregate demand (for example, due to business
pessimism) so that the AD curve shifts leftward from AD to AD1.
Fig. 20.10: Bad Deflation
 Whereas the AD-AS model predicts a drop in the price level, or

deflation, this is unlikely to occur over a short period of time for the
reasons discussed above, accounting for the highly infrequent
occurrence of deflation.
 However if low aggregate demand persists over a long period, the
price level falls from P to P1. In this case, output falls from Y to Y1,
which may result in higher unemployment. Bad deflation runs the risk
of developing into a deflationary spiral.
 This is ‘bad’ deflation because it is associated with recession, falling
incomes and output, and cyclical unemployment.
 [Consumers may delay their purchases, expecting prices to fall further

in the future. Firms, seeing lower demand, may not invest and may
reduce the number of workers they employ. Some debtors may get
into difficulty and this may cause banks, in turn, to get into difficulty
with the risk of some going out of business, losing their customers’
money. These effects will reduce demand further and economic
activity will decline again.]
 These are the circumstances that characterised the deflation of the
Great Depression during the 1930s in the US, and more recently in
Japan.
 Good Deflation: Good deflation occurs as a result of an increase in

aggregate supply (AS).
 ‘Good’ deflation, on the other hand, can be shown in a Fig. 20.9
below which shows an increase in aggregate supply caused by a
rightward shift from AS to AS1, with the AD curve constant (or also
shifting to the right but by less than the AS shift), so that the new
point of equilibrium occurs at a lower price level, resulting in a fall in
the price level from P to P1 and a rise in real GDP from Y to Y1.
 [Advances in technology, for instance, may create new methods of
production and lower costs of production. As well as an increase in
output, employment may rise and the international competitiveness of
the country’s products may increase.]
Fig. 20.9: Good Deflation
 This is held to be ‘good’ deflation because it is associated with

economic expansion, rising incomes and output, increasing
employment and economic growth.
 Some economists argue that it was under such circumstances that the
deflation of Britain and the United States in the late 19th century
occurred.
 The fear in 2003 that deflation might occur in the US possibly
involved both kinds of deflation. It was held that the downward
pressure on prices was due partly to advances in information
technology (causing an increase in aggregate supply) and partly to
falls in aggregate demand.
 However, it must be stressed that while it may be possible to make an

analytical distinction between ‘good’ and ‘bad’ deflation, no deflation is
ever good.
 An important reason is that as we have seen above, deflation discourages
spending because it reduces borrowing due to increases in the real value of
debt, and also because consumers postpone purchases in the expectation
that prices will fall. These factors cause aggregate demand to fall regardless
of the causes of deflation.
 For these reasons, deflation is generally feared and is considered by
economists to be a greater threat than inflation.
 TIP: Remember that whereas inflation caused by decreases in AS tends to
be more harmful than inflation caused by increases in AD, it is the change
in AD (decrease) that is more harmful in the case of deflation.
ACTIVITY 20.9
 1 In mid-2019, the US central bank, the Federal Reserve, was worried

that the inflation rate was too low. It was concerned that the US might
experience deflation.
 Reasons for likely deflation included advances in technology,
increased international competition, the fall in house prices and, in
some cases, casual employment replacing permanent employment.
 In groups of four:
 a On cards, write the four possible reasons why deflation may have
occurred in the US in 2019. Each member of the group selects one
card. They should then explain to the rest of the group why the reason
selected could lead to a fall in the price level.
ACTIVITY 20.9
 b Find out your country’s inflation rate. Then produce a wallchart

with four products that have risen in price by more than the inflation
rate, four that have risen by less than inflation and four that have
fallen in price. Include pictures of the products and, in each case, a
possible reason why the price rise is above the inflation rate, below
the inflation rate or why the price has fallen.
 REFLECTION: How did you find that explaining a reason helped
you to understand it?
 How confident were you in answering any questions the rest of the
group asked?
 How did producing the wallchart help you understand the nature of
inflation?
ACTIVITY 20.10
 Mexico’s central bank aims for an inflation rate of 3%. Towards the
end of the second decade of the 21st century, Mexico’s inflation rate
fell. This was largely because of a slowdown in the rise of the price of
food and energy.
 However, it was expected that the inflation rate might be higher in
2020 because of the increase in the national minimum wage in 2019
and the expected fall in the exchange rate.
 Over the period shown, Chile’s central bank also had a 3% inflation
rate target while Brazil’s central bank target was 4.25%.
 Table 20.4 shows the inflation rates in Chile, Brazil and Mexico
between 2013 and 2019.
Table 20.4: Inflation rates (% Change in CPI)
in Chile, Brazil and Mexico, 2013–19
Year Brazil Chile Mexico
2013 6.2 1.8 3.8
2014 6.3 4.7 4.0
2015 9.0 4.4 2.7
2016 8.7 3.8 2.8
2017 3.5 2.2 6.0
2018 3.7 2.3 4.9
2019 3.6 2.3 3.8
ACTIVITY 20.10
 1 Explain why a slowdown in the rise of the price of food and energy
may reduce a country’s inflation rate.
 2 Explain why the change in Mexico’s foreign exchange rate may
have caused inflation in 2019.
 3 Using Table 20.4, explain why investment may have been higher in
Chile between 2017 and 2019 than in Brazil and in Mexico.
 4 Using Table 20.4, compare how successful the countries’ central
banks were in meeting their inflation targets.
 5 Ask another learner to assess your answers while you assess your
partner’s answers. Did you both make similar points? Did your
partner make additional points? Did you learn from each other?
 1 Explain what happens to your real income (your purchasing power)

in each of the following situations:
 (a) your nominal income increases by 5% and the rate of deflation is
3%,
 (b) your nominal income falls by 10%, and the rate of deflation is 2%,
 and (c) your nominal income falls by 3% and the rate of deflation is
4%. (You should think of deflation as negative inflation.)
 2 (a) What are some negative consequences of deflation?
 (b) Why can deflation be especially serious for an economy?
 3 Why is a zero rate of inflation (a constant price level) not desirable?
 4 Why does deflation occur rarely in the real world?
Inflation versus Deflation
 Most governments aim for a low and stable rate of inflation

rather than a fall in the price level.
 This is for two key reasons.
 Firstly, there is the belief that a low rate of demand-pull
inflation may promote economic growth.
 Secondly, measures of inflation tend to overstate the inflation
rate because they tend to take full account of quality
improvements and the effect of consumers switching to
lower-priced products.
Possible relationships b/w Unemployment and Inflation:
The Phillips Curve
 The Phillips Curve: Discuss, using a short-run Phillips curve diagram, the
view that there is a possible trade-off between the unemployment rate and
the inflation rate in the short run.
 The Phillips curve is concerned with the relationship between
unemployment and inflation. In the late 1950s, the New Zealand economist
A.W. Phillips published a study showing that there appeared to be a long-
term negative relationship between the unemployment rate and the rate of
change in nominal (money) wages; this relationship was later extended by
economists to apply to the relationship between unemployment and
inflation.
 The relationship showed that the lower the rate of inflation, the higher the
unemployment rate; and the higher the rate of inflation, the lower the
unemployment rate.
The Phillips Curve
 This relationship is shown in Fig. 10.6(a) below, where the unemployment
rate is measured along the horizontal axis, and the rate of inflation along
the vertical axis. (Note that the vertical axis does not measure the price
level, as in the AD-AS model.)
 The Phillips curve suggests that if there is a constant negative relationship
between the two variables, then every economy faces a trade-off between
inflation and unemployment: it can choose between a relatively low rate of
inflation and a higher unemployment rate, such as point a on the curve, or
a higher rate of inflation and a lower unemployment rate, such as point d.
Whereas, ideally, it would be preferable for any economy to have low
inflation and low unemployment, such as point e, this is not possible
according to the theory of the Phillips curve, as the only achievable points
are those on (or close to) the curve.
Fig. 10.6: The Phillips Curve
The Phillips Curve
 Reason behind the Shape of the Phillips Curve: The reasoning behind
the shape of the Phillips curve can be illustrated by use of the AD-AS
model, shown in Fig. 10.6(b) above. Assume a fixed, upward-sloping
SRAS curve, and imagine a succession of aggregate demand increases
(which could be caused by any of the (non-price level) factors we are
already familiar with from Chapter/Slide on AD-AS Model.
 As aggregate demand shifts from AD1 to AD2, the price level rises from
Pl1 to Pl2, the level of real GDP increases from Y1 to Y2, and the level of
unemployment correspondingly falls.
 The same process is repeated as aggregate demand increases from AD2 to
AD3, and then to AD4, and so on. With every increase in aggregate
demand, we have an increase in the price level and a fall in unemployment.
The Phillips Curve
 It follows, then, that we can simply think of each point on the Phillips
curve (such as a, b, c or d) as corresponding to the point of intersection of
SRAS with a different AD curve (a, b, c or d).
 The ‘choice’ of where to be on the Phillips curve in part (a) thus
corresponds to a ‘choice’ of AD curve in part (b) of the figure.
 Summary: According to the short-run Phillips curve in Fig. 10.6(a)
above, there is a negative relationship between the rate of inflation and
the unemployment rate, suggesting that in the short run policy-makers
can choose between the competing alternatives/policy objectives of low
inflation or low unemployment by using policies that affect aggregate
demand.
Definitions
Summary
KEY TERMS
 Aggregate Demand –Vs- Aggregate Supply, Inflationary

Gap –Vs- Deflationary Gap

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BBM-ME-II

 This chapter is concerned with another one important macroeconomic

 In this chapter you will learn how to:

 KEY CONCEPT LINK: Progress and development: Price stability

 Inflation, disinflation and deflation: Distinguish between

 Further, an increase in the general price level does not

 Explanation: For instance, an inflation rate of 6% would

 In such cases, the currency usually has to be replaced by a

 Deflation is defined as a sustained decrease (fall) in the general price

 Students sometimes confuse the difference between changes in the

 Explanation: Disinflation occurs when the inflation rate falls

 To assess changes in the cost of living, governments

 Explain that economists measure a core/underlying rate of inflation

 Explain that a producer price index measuring changes in the

 Price level changes measured by PPIs are considered to be predictors

 1 (a) Distinguish between inflation, deflation and disinflation, and provide

 Money values, or nominal values, are the values of the prices

 Calculating Real Income: For example, a worker’s wages may rise

 For instance, if the money interest rate (sometimes known as the

 Calculate the change in real wages for the countries shown in

Country Change in Money Wages (%) Inflation Rate (%)

Belarus 13.5 4.9

Estonia 7.4 3.5

Russia 3.0 2.9

Serbia 9.0 2.0

Ukraine 17.4 9.9

 There are two main causes of inflation: demand-pull inflation and

 The economy experiences an increase in aggregate demand appearing

 Demand-pull inflation involves an excess of aggregate demand over

 A rise in aggregate demand will have a greater impact on the price

 Monetarists argue that the key cause of higher aggregate demand is

 Cost-push inflation: Explain, using a diagram, that cost-push

 Cost-push inflation is analysed only by means of the monetarist/new

 In Chapter/Slide 6 on AD-AS, we saw that a decrease in SRAS poses

 Cost-push inflation is caused by a fall in aggregate supply, in turn

 Higher wages can cause a wage–price (cost) spiral. Workers gain a

 An increase in firms’ profit margins will also increase costs of

 3 What other information might have been useful in helping you

 1 Using appropriate diagrams, explain the difference between demand-pull

 Inflation has both possible costs and potential benefits.

 These relationships illustrate some important points. Inflation leads to

 Discuss the possible consequences of a high inflation rate, including

 • People who receive fixed incomes or wages (Contd…).

 Groups who gain from inflation include:

 Groups who gain from inflation include (Contd…):

 Uncertainty: Inability to accurately predict what inflation will be in the

 International (export) competitiveness: When the price level in a country

 The effects of inflation depend on:

 1 Using a numerical example, explain the relationship

 3 (a) Inflation results in redistribution of purchasing power.

 Discuss the possible consequences of deflation, including high

 From an analytical point of view, we can make a distinction between

 Whereas the AD-AS model predicts a drop in the price level, or

 [Consumers may delay their purchases, expecting prices to fall further

 Good Deflation: Good deflation occurs as a result of an increase in

 This is held to be ‘good’ deflation because it is associated with

 However, it must be stressed that while it may be possible to make an

 1 In mid-2019, the US central bank, the Federal Reserve, was worried

 b Find out your country’s inflation rate. Then produce a wallchart

Slide-09-Price Stability & Inflation

Slide-09-Price Stability & Inflation

Slide-09-Price Stability & Inflation