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Inflation
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Detailed notes on Inflation
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InflationIntro
Inflation refers to rising price levels; deflation refers to falling price levels. The annual rate of
inflation measures the annual percentage increase in price. If the rate of inflation is negative,
then prices are falling and we are measuring the rate of deflation.
Typically, inflation relates to consumer prices. The government publishes a consumer price
index (CPI) each month, and the rate of inflation is the percentage increase in that index over
the previous 12 months.
A broader measure of inflation relates to the rate at which the prices of all domestically
produced goods and services are changing (known as GDP deflator).
There are also rates of inflation reported for a variety of goods and services e.g. published
wages (wage inflation, house prices, import prices, food price, prices after tax etc.
When there is inflation, you have to be careful in assessing how much national output,
consumption, wages etc. are increasing e.g. real national output, real wages etc.
The cost of inflation
People frequently make mistakes when predicting the rate of inflation and are not able to
adapt fully to it. This leads to the following problems:
• Redistribution. Inflation redistributes income away from those on fixed incomes and
those in a weak bargaining position, to those who can use economic their economic
power to gain large pay, rent, or profit increases. It redistributes wealth to those with
assets (e.g. property) that rise in value rather rapidly during periods of inflation, and
away from those with savings that pay rates of interest below the rate of inflation
(hence inflation eroding its value).
• Uncertainty and a lack of investment. Inflation tends to cause uncertainty in the
business community, especially when the rate of inflation fluctuates. If it is difficult
for firms to predict their costs and revenues, they may be discouraged from investing.
This will reduce the rate of economic growth. On the other hand, government policies
to reduce the rate of inflation may themselves reduce the rate of economic growth
(e.g. cutting spending, raising taxation, raising interest rates).
• Balance of payments. Inflation is likely to worsen the balance of payments. If a
country suffers from relatively high inflation rates, its exports will become less
competitive in world markets. At the same time, imports will become relatively
cheaper than home-produced goods. Thus exports will fall, and imports will rise. As a
result, the balance of payments will deteriorate and/or the exchange rate will fall, or
interest rates will have to rise.
, • Resources. Extra resources are likely to be used to cope with the effects of inflation.
For instance, accountants and other financial experts may have to be employed by
companies to help them cope with uncertainties caused by inflation.
The problems are likely to become more serious the higher the rate of inflation becomes and
the more the rate fluctuates.
The cost of inflation may be relatively mild if the inflation rate is kept to single figure. They
may be very serious however, if the inflation gets out of hand. If inflation develops into
‘hyperinflation’, with prices rising perhaps by several hundred or even thousand per cent per
year, the whole basis of the market economy will be destabilised. Firms constantly raise
prices in an attempt to cover their rocketing costs. Workers demand huge pay increases in an
attempt to stack ahead of the rocketing cost of living. Consequently, prices and wages chase
each other in an ever-rising inflationary spiral. People will no longer want to save money.
Instead they will spend it as quickly as possible before its value deteriorates any further.
Aggregate demand and supply and the level of prices
The level of prices in the economy is determined by the interaction of aggregate demand and
aggregate supply.
Aggregate demand curve
The aggregate demand curve shows how much national output (real GDP) will be demanded
at each level of prices (GDP deflator).
The three main reasons the aggregate demand curve slopes downwards are as follows:
• If the prices rise, people will be encouraged to buy fewer of the country’s product and
more imports instead as they are cheaper. The country will therefore also sell fewer
exports. Thus aggregate demand will be lower.
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