Inflation and Deflation


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Inflation and Deflation key information for ECON4 - Building on the knowledge you should have from ECON2

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Inflation and Deflation

  1. 1. Aquinas College Economics DepartmentInflation & DeflationHow its calculated, the causes,consequences, and the scarysituation that is deflationECON4
  2. 2. Aquinas College Economics DepartmentDefinitionsInflation: a sustained increase in the general price levelDeflation: a fall in the general price levelCPI – Consumer Price Index
  3. 3. Aquinas College Economics DepartmentInflationA sustained increase in the price levelNormally measured in the UK through theConsumer Price Index.UK government target for inflation is 2%This target has an limit of +/- 1% as it can bedifficult to bring inflation under control
  4. 4. Aquinas College Economics DepartmentConsumer Price IndexMeasure of UK InflationMeasures the prices of a basket of goodsGoods are weighted so it can reflect changes inspendingInformation from the Family Expenditure Surveygives the information about spending paterns
  5. 5. Aquinas College Economics DepartmentThe Basket of GoodsSource: The GuardianThe basket is changeddepending on what peopleare buyingFilm Camera’s have beenremoved from the basketbut iPad’s and other tabletcomputers have beenadded
  6. 6. Aquinas College Economics DepartmentWeightingUsing data from the FES government assignsweights to each product in the basket of goodsSpending is broken down into 14 categoriesIf Housing costs make up 30% of total spendingthen it is given a weighting of 30% in the basketof goodsThis weighting is then multiplied by the priceindex for that year
  7. 7. Aquinas College Economics DepartmentIndex NumbersWhen comparing figures over years, indexnumbers are usedYou establish a base year which becomes 100.0then other years are worked out accordingly
  8. 8. Aquinas College Economics DepartmentIndex ExampleYear Index2007 100.02008 101.32009 130.02010 982007 is being used as the base yearIn 2008 we can see that prices have increasedby 1.3% from 2007In 2009 prices had increased by 30% on 2007Be Warned!!!!Caluclating the change between 2008/09 canbe more difficultYou must use the percentage changecalculation:(130.0-101.3) / 101.3 x 100 = 28.3%
  9. 9. Aquinas College Economics DepartmentLimitations of CPI1. It is an average so is not entirelyrepresentative2. House prices are not included3. CPI doesn’t include quality of the goods somay over-estimate the rate of inflationexperienced
  10. 10. Aquinas College Economics DepartmentCauses of InflationInflation can come from within an economy or itcan come from outside the national economyAt A2 you need to know the three main ways inwhich inflation is caused
  11. 11. Aquinas College Economics DepartmentDemand Pull InflationCaused by a rise indemand when aneconomy has littlecapacityAD will increaseleading to higherpricesPriceLevelGDPLRASADAD1PP1Y Y1
  12. 12. Aquinas College Economics DepartmentCost Push InflationCaused by increasingcosts of productionfaced by business1. Rise in rawmaterial cost2. Rising wages3. Higher rates ofVAT4. Wage-Price SpiralsPriceLevelGDPASADPP1YY1AS1
  13. 13. Aquinas College Economics DepartmentIncrease in Money SupplyQuantity Theory of Money says that an increasein the money supply will cause price levels toriseKey argument of MonetaristsSee separate PowerPoint on QTM
  14. 14. Aquinas College Economics DepartmentConsequences of InflationConsequence ExplanationGlobal Competitiveness Makes UK Goods more expensive on foreignmarkets [BoP issues]Investment As inflation creates uncertainty investmentlevels fall‘Menu Costs’ Admin costs to business when changing prices‘Shoe-Leather Costs’ Cost to consumers who shop aroundDistribution of Income Savers lose out with a real interest rateEmployer-Employee Relationship Workers demand higher pay, resulting in awage-spiralFiscal Drag When tax exempt amounts are not increased inline with inflation meaning tax payers may bedragged into the next tax bandHyperinflation Currency is effectively worthless and a bartereconomy appears
  15. 15. Aquinas College Economics DepartmentDeflationBenign deflation: fallings prices resulting fromtechnological advances across the economye.g. Computer PricesMalevolent Deflation: falling prices resultingfrom a significant downturn in economic activity- Real economic problemDeflation: a fall in the general price level
  16. 16. Aquinas College Economics DepartmentDeflationIf malevolentdeflation existsthen a downwardsmultiplier effectcan take placeTips the economiccycle intorecession
  17. 17. Aquinas College Economics DepartmentAS Level Revision Site (ECON1, ECON2)• Level Revision Site (ECON3, ECON4)• Economics on Twitter• Links