Inflation and Deflation (Copy)

4.8.1 Definition of Inflation and Deflation

• Inflation: A sustained increase in the general price level of goods and services in an economy over time.
• Deflation: A sustained fall in the general price level of goods and services in an economy over time.
• Disinflation: A fall in the rate of inflation (prices still rising but more slowly).
• Hyperinflation: Extremely rapid and uncontrolled inflation (e.g. >50% per month).
• Price stability: Low and steady inflation, often targeted at around 2–3% per year in many economies.

Diagram: Price level changes over time

Price Level ↑
            |       /
            |     /
            |   /
            | /
            |/___________________→ Time
                Inflation trend

Price Level ↑
            | 
            |  
            |    
            |      
            |        ___________→ Time
                  Deflation trend

4.8.2 Measurement of Inflation and Deflation

• Consumer Prices Index (CPI):
  • A measure of the average change in prices of a basket of goods and services.
  • Basket is updated regularly to reflect consumer spending patterns.
  • Weighted average: items given different importance based on household spending shares.
• Steps in measuring CPI:
  1. Survey household expenditure to identify representative basket.
  2. Assign weights to items based on spending importance.
  3. Collect price data monthly from shops/services.
  4. Calculate weighted average price index.
• Formula for Price Index:

Price Index = (Current year basket cost ÷ Base year basket cost) × 100

• Inflation rate formula:

Inflation rate = ((Index this year − Index last year) ÷ Index last year) × 100

Example:

• CPI in 2024 = 120
• CPI in 2025 = 126
• Inflation rate = (126 − 120)/120 × 100 = 5%

Diagram: CPI calculation

Goods basket → Weights → Prices → Weighted average → CPI Index

4.8.3 Causes of Inflation and Deflation

Causes of Inflation

• Demand-pull inflation:
  • When total demand > total supply.
  • Causes: higher consumer spending, government spending, exports, low interest rates.
  • Diagram (AD shifts right):

Price Level ↑
     |       AD2
     |      /
     |     /
     |    /
     |AD1/_____
     |   /
     |  /
     |_/________________ Output →
          AS

• Cost-push inflation:
  • Rising production costs push prices up.
  • Causes: higher wages, raw material costs, oil prices, taxes.
  • Diagram (AS shifts left):

Price Level ↑
     |       AS2
     |      /
     |     /
     |AS1 /
     |   /
     |  /
     |_/___________ AD
     |________________ Output →

Causes of Deflation

• Demand-side (fall in AD):
  • Weak consumer confidence, recession, falling incomes, high interest rates.
• Supply-side (rise in AS):
  • Technological improvements, productivity growth, falling raw material costs, cheaper imports.

Diagram: Demand-side deflation (AD shifts left)

Price Level ↑
     |AD1
     | 
     |  
     |    AD2
     |    _______
     |             
     |______________ Output →
                 AS

4.8.4 Consequences of Inflation and Deflation

Consequences of Inflation

• Consumers:
  • Fall in real incomes if wages don’t rise as fast as prices.
  • Menu costs (firms must change prices frequently).
• Workers:
  • Demands for higher wages → wage-price spiral.
• Savers:
  • Real value of savings falls (money buys less).
• Lenders:
  • Lose if loans are repaid in money with lower value.
• Firms:
  • Costs of production rise (if wages/inputs increase).
  • Uncertainty discourages investment.
  • Exports become less competitive if domestic inflation > foreign inflation.
• Economy:
  • Loss of international competitiveness.
  • Inequality may rise (those on fixed incomes suffer).

Consequences of Deflation

• Consumers:
  • May delay spending (expect prices to fall further).
• Workers:
  • Higher risk of unemployment as firms cut production.
• Savers:
  • Real value of savings increases.
• Lenders:
  • Gain as debts repaid with money of higher value.
• Firms:
  • Revenue falls, profits shrink, layoffs increase.
• Economy:
  • Risk of recession, falling AD, deflationary spiral.

Diagram: Deflationary spiral

Falling demand → Falling prices → Falling revenue → Job cuts → Lower incomes → Falling demand again

4.8.5 Policies to Control Inflation and Deflation

Policies to Control Inflation

• Demand-pull inflation:
  • Contractionary fiscal policy: raise taxes, cut government spending.
  • Contractionary monetary policy: raise interest rates, reduce money supply.
• Cost-push inflation:
  • Supply-side policies: improve productivity, reduce business taxes, subsidies.
  • Control wage demands via labour market reforms.

Policies to Control Deflation

• Expansionary fiscal policy: increase government spending, cut taxes.
• Expansionary monetary policy: lower interest rates, quantitative easing.
• Supply-side policies: encourage investment and innovation to sustain employment.

Diagram: Policy effects on AD

Price Level ↑
     |AD2
     |  
     |   
     |    
     |AD1  _______
     |       
     |        
     |__________ Output →
                  AS