Inflation and Deflation
Written by Amina Meirkhan | Proofread by Yasmin Uzykanova
Definitions:
Aggregate demand - total demand in the economy including consumption, investment, government expenditure and exports minus imports.
Deflation - period where the level of aggregate demand is falling.
Inflation - rate at which prices rise; a general and continuing rise in prices over a period of time.
Consumer price index (CPI) - measure of the general price level (excluding housing costs).
Retail price index (RPI) - measure of the general price level, which includes house prices and council tax.
Demand-pull inflation - inflation caused by too much demand in the economy relative to supply.
Cost-push inflation - inflation caused by rising business costs.
Interest rates - prices paid to lenders for borrowed money; the price of borrowing money.
Monetarists - economists who believe there is a strong link between growth in the money supply and inflation
Purchasing power of money - amount of goods and services that can be bought with a fixed sum of money.
Menu costs - costs to firms of having to make repeated price changes.
Shoe leather costs - costs to firms and consumers of searching for new suppliers when inflation is high.
Hyperinflation - very high levels of inflation; when rising prices get out of control.
Balance of payments - record of all transactions relating to international trade.
Deflation is the term used to describe a fall in average prices, however, it can also be used to describe a slowdown in the economy - a period when aggregate demand is falling.
In many countries, inflation is measured using CPI. Every month, the government records the prices of about 600 goods and services purchased by over 7000 families. An average monthly price is then calculated and converted into an index number.
Types of inflation:
Demand-pull inflation - in any market, if demand increases, there will be an increase in price and this will be the same for the whole economy. Demand-pull inflation can be caused by: rising consumer spending encouraged by tax cuts or low interest rates, sharp increases in government spending, rising demand for resources by firms, and booming demand for exports.
Cost-push inflation - when businesses face rising costs, they increase their prices to protect their profit margins, as a result, inflation is caused. Cost-push inflation can be caused by rising costs of imported goods, wage increases, and increases in taxation.
Monetarists believe there’s a strong link between inflation and growth in the money supply. Inflation may be caused when households, firms and the government borrow more money from banks to fund extra spending, which adds to the money supply because more bank deposits lead to increased bank balances. Extra money lent creates more demand and prices increase. This is more likely to happen if interest rates are low. If interest rates rise, borrowing will fall as it becomes expensive, the money supply will slow down and demand will fall, decreasing inflation.
Impacts of inflation:
Prices - prices rise, as a result the purchasing power of money is reduced and people as much with their income, therefore, households will experience lower living standards. However, if incomes rise as fast, or faster than prices, this may not be a problem.
Wages - when prices rise, workers need higher wages to compensate for rising prices and lower purchasing power of money. However, as a result of higher wages, firms might need to raise their prices to not lose profit. This can result in a wage-price spiral.
Exports - if inflation is high, firms might find it difficult to sell their products overseas because the price of exports rises. As a result, demand for exports falls and affects the balance of payments negatively. This will also result in job losses for people employed by businesses that sell their goods overseas.
Unemployment - as aggregate demand rises, firms will want to increase their output to sell more and gain profit. So they will need to recruit more workers, which reduces unemployment. A trade-off exists between inflation and unemployment, so if the government tries to reduce inflation, they might need to accept higher levels of unemployment.
Menu costs - as demand grows and prices rise firms will have to increase their prices frequently, so they will experience costs from changing prices on brochures, menus, websites and informing the sales staff. These are called menu costs because it costs money for a restaurant to constantly print out new menus with new prices.
Shoe leather costs - when prices rise, consumers and businesses will have to spend more time looking for goods for a lower price, so they will experience costs. These are called shoe leather costs because when you shop around for too long, your shoes start to wear down.
Uncertainty - due to constant and unstable rise in prices, firms do not know what the prices will be in the next 3 or 6 months, so it is difficult for them to plan their activities ahead. Making investment decisions will also be hard, and firms will find it hard to set exact prices for long-term contracts.
Business and consumer confidence - inflation will make consumers more cautious, they will save more, and borrow less, which will reduce demand, and this is not good for job security in the economy. Businesses also lose confidence and postpone growth plans, reduce spending on product development, and don't take risks. This will result in a decrease of economic growth. If hyperinflation occurs, money might not even be accepted as a means of payment, so the country can be destabilised.
Investment - investment decreases due to uncertainty about future prices; this will have a negative impact on economic growth and future employment levels.
