4.8 – Inflation and Deflation

Inflation

Inflation is the general and sustained rise in the level of prices of goods and services in an economy over a period of time.
For example, the inflation rate in UK in 2010 was 4.7%. This means that the average price of goods and services sold in the UK rose by 4.7% during that year.

Inflation is measured using a consumer price index (CPI) or retail price index (RPI).
The consumer price index is calculated in this way:

• A selection of goods and services normally purchased by a typical family or household is identified.
• The prices of these ‘basket of goods and services’ will then be monitored at a number of different retail outlets across the country.
• The average price of the basket  in the first year or ‘base year’ is given a value of 100.
• The average change in price of these goods and services over the year is calculated.
• If it rises by an average of 25%, the new index is 125% * 100 = 125%. If in the next year there is a further average increase of 10%, the price index is 110% * 125 = 137.5%. The average inflation rate over the two years is thus 137.5 – 100 = 37.5%

Causes of Inflation

• Demand-pull inflation: inflation caused by an increase in aggregate demand is called demand-pull inflation. This is also defined as the increase in price due to aggregate demand exceeding aggregate supply. Demand could rise due to higher incomes, lower taxes etc. The demand curve will shift right, causing an extension in supply and  a rise in price.
• Cost-push inflation: inflation caused by an increase in cost of production in the economy. The cost of production could rise due to higher wage rate, higher indirect taxes, higher cost of raw materials, higher interest on capital etc. The supply curve will shift left causing a contraction in demand and a rise in price.
• A lot of economists agree that a rise in money supply in contrast with output is the key reason for inflation. If the GDP isn’t accelerating as much as the money supply, then there will be a higher demand which could exceed supply, leading to inflation.

The consequences of inflation

• Lower purchasing power: when the price level rises, the lesser number of goods and services you can buy with the same amount of money. This is called a fall in the purchasing power. When purchasing power falls, consumers will have to make choices on spending.
• Exports are less internationally competitive: if the prices of exports are high, its competitiveness in international markets will fall as lower priced foreign goods will rival it. This could lead to a current account deficit if exports lower (especially if they are price elastic).
• Inflation causing inflation‘: during inflation, the cost of living in the economy rises as you have to pay more for goods and services. This might cause workers to demand higher wages increasing the cost of production. If the price of raw materials also increase, the cost of production again increases, causing cost-push inflation.
• Fixed income groups, lenders, and savers lose: a person who has a fixed income will lose as he cannot press for higher wages during inflation (his/her real wages fall as purchasing power of his/her wages fall). Lenders who lent money before inflation and receive the money back during inflation will lose the value on their money. The same amount of money is now worth less (here, the people who borrowed gain purchasing power). Savers also lose because the interest they’re earning on savings in banks does not increase as much as the inflation, and savers will lose the value on their money.

Policies to control inflation

• Contractionary monetary policy that will reduce demand: contractionary monetary policy is the most popular policy employed to curtail inflation. Raising interest rates will discourage spending and investing (as cost of borrowing rises) and reduce the money supply in the economy, helping cut down on demand. But this depends a lot on the consumer and business confidence in the economy. Spending and investing may still continue to rise as confidence remains high. There is also a considerable time lag for monetary policy to take effect.
• Contractionary fiscal policy that will reduce demand: raising taxes will discourage spending and investing and cutting down on government spending will reduce aggregate demand in the economy, helping bring down the price level. However, this is an unpopular policy only employed when inflation is severe.
• Supply side policies: supply-side policies such as privatisation and deregulation hope to make firms competitive and efficient, and thus avoid inflationary pressures. But this is a long-term policy only helping to keep the long-term inflation rate stable. Sudden surges in inflation cannot be addressed using supply side measures
• Exchange rate policy: Appreciating the domestic currency can lower import prices helping reduce cost-push inflation arising from expensive imported raw materials. It also makes export more expensive, helping lower the export demand in the economy as well as creating incentives for exporting firms to cut costs to remain competitive.

Deflation

Deflation is the general fall in the price level.

Deflation is also measured using CPI, but instead of showing figures above 100, it will show an index below 100 denoting a deflation. For example, a drop in the average prices of the basket of goods in a year is 10%, the deflation will be 100 – (90% * 100 = 90%) = 10%.

Causes of deflation

• Aggregate supply exceeding aggregate demand: when supply exceeds demand, there is an excess of output in the economy not consumed, causing prices to fall.
• Demand has fallen in the economy: during a recession, a fall in demand in the economy causes general prices to fall and cause a deflation.
• Labour productivity has risen: higher output will lead to lower average costs, which could reflect as lower prices for products.
• Technological advance has reduced cost of production, pulling down cost-push inflation.

Consequences of deflation

• Lower prices will discourage production, resulting in unemployment.
• As demand and prices fall, investors will be discouraged to invest, lowering the output/GDP.
• Deflation can cause recession as demand and prices continue to fall and firms are forced to close down as enough profits are not being made.
• Tax revenue of the government will fall as economic activity and incomes falls. They might be forced to borrow money to finance public expenditure.
• Borrowers will lose during a deflation because now the value of the debt they owe is higher than when they borrowed the money.
• Deflation will increase the real debt burden of the government as the value of debt money increases.

Policies to control deflation

• Expansionary monetary policy to revive demand: cutting interest rates will encourage more spending and investment in the economy which will stimulate prices to rise. However, if interest rate is already at a very low point where decreasing it any further won’t increase spending, because people still prefer to save some money and pay off debts, and banks are not willing to lend at a very low interest rate, (this situation is called a liquidity trap), then cutting interest rates will have no effect on spending.
• Expansionary fiscal policy to revive demand: increasing government spending in the economy, especially in infrastructure will help raise demand, along with cuts in direct taxes. The money for this expenditure can be created via quantitative easing (selling government bonds to the public).
• Devaluation: devaluing the currency through selling domestic currency and/or increasing the money supply will cause export prices to fall, encouraging production of exports, resulting in higher demand; and also increase prices of imported products which will raise costs and prices for products in the economy.
• Change inflation expectations: when a deflation is expected, businesses won’t increase wages and consumers won’t pay higher prices (because they expect prices to fall in the future). This will cause the deflation they expected. But if the monetary authorities indicate that they expect higher inflation, firms will pay their workers more and consumer will spend more now, avoiding a deflation.

Notes submitted by Lintha

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