Inflation & Deflation

1. Inflation & Deflation • Recap & move forward… 1

2. Recap • What was the more recent ‘FIVE’ causes of UK’s rise in inflation last month? 2

3. Recap • What was the more recent ‘FIVE’ causes of UK’s rise in inflation last month? • F= Fuel • I = Imports create higher costs • V = VAT • E= exchange rates 3

4. Recap • In theory – what are the 2 different types of inflation? • Demand pull inflation • Cost push inflation 4

5. Recap • Can you draw me a demand pull inflation diagram (show SR & LR AS) 5

6. DEMAND PULL INFLATION In the LR, workers are not willing to sacrifice Leisure time for more overtime…. But still have high wage expectations…. demand pull inflation SRAS2 LRAS Price Level SRAS AD1 AD 0 Y2 Y1 Real National Output 6

7. Recap • Can you draw me a cost push inflation diagram (show SR & LR AS) 7

8. Draw an Classical AD/AS diagram LRAS SRAS2 Price Level SRAS1 AD 0 Y2 Y1 Real National Output 8

9. Deflation • Is it good or bad? 9

10. Deflation • Deflation is a sustained fall in the general price level • A sustained period of negative inflation • The internal value of money rises 10

11. Deflation for some products 11

12. What effects do you think this had on the economy? What’s the start & end points? Describe the changes in the data provided. What’s the trend? 12

13. The diagrams • – demand side cause of deflation 13

14. DEMAND PULL Deflation… LRAS Price Level SRAS AD AD1 0 Y2 Y1 Real National Output 14

15. Demand side causes of Deflation • A Large (adverse) Fall in AD • Exogenous shocks to the economy • A global recession leading to a fall in exports and investment • A rise in the exchange rate (leading to lower exports and cheaper imports) • Declines in domestic and international asset prices • Deliberate attempts by macroeconomic policy to reduce AD through tightening of fiscal and/or monetary policy 15

16. Multi choice… 16

17. Demand-pull inflation is most likely to be caused by • A total spending exceeding productive capacity. • B an increase in output. • C a rise in raw material prices. • D a rise in interest rates. 17

18. An economy is most likely to be in the boom phase of the trade cycle when there is a rise in • A business pessimism. • B the savings ratio. • C spare capacity. • D the demand for imports. 18

19. Real incomes rise whenever • A nominal incomes rise. • B the price level rises by more than nominal incomes. • C nominal incomes rise by more than the price level. • D the rate of inflation slows down. 19

20. Inflation article • Read • use highlighters to select key positive & negative issues 20

21. What’s so BAD about inflation? • “RPI is an aggregate figure” – what does this mean? • Why are interest rates on mortgages such an important monetary tool to control inflation? • What is the difference between nominal and real prices? • The article identifies 4 problems of inflation. What are they? 21

22. The diagrams • – supply side cause of deflation 22

23. SR Cost ‘push’ deflation LRAS Price Level SRAS1 SRAS2 AD 0 Y2 Y1 Real National Output 23

24. LR Cost ‘push’ deflation LRAS LRAS Price Level SRAS1 AD 0 Y1 Real National Output Y2 24

25. Supply side causes of deflation • An Increase in Long Run Aggregate Supply • The supply potential of the economy has been boosted by a series of beneficial shocks such as • Impact of rapid technological advances • Reductions in the international prices of commodities and capital goods • Higher productivity which drives down unit cost of production • Exploitation of economies of scale leading to lower LRAC • Excess supply in some industries due to over-investment in new capital machinery i.e. deflation results from a persistent demand deficit over existing and potential productive capacity. 25

26. Deflation – good and bad points! Impact on Households? Consumers? Employees? Businesses? 26

27. Consequences of Deflation • Holding back on spending: • Consumers may opt to postpone demand if they expect prices to fall further in the future • Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on confidence • Mortgage payers on fixed mortgage interest rates will see the real cost of servicing their debt increase • The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices • Lower profit margins: This can lead to higher unemployment as firms seek to reduce their costs. • Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence –leading to further declines in AD. Higher savings can lead to the paradox of thrift 27

28. Past paper practice • I would suspect that your exam paper will be about recessionary issues – one being Deflation! 28

29. 29

30. QUESTIONS • Explain what is meant by the term “deflation”. (4 marks) • With reference to Extract 1, explain the effect on GDP of the change in asset prices in 1990. (8 marks) • Explain why “deflation needn’t be all bad”? (line 28, extract 2) (8 marks) • With reference to the extracts, examine the problems associated with a long period of deflation. (12 marks) • Assess the relative effectiveness of using monetary and fiscal policy to move the economy out of a period of deflation. (12 marks) • How might the continuing deflation in Japan affect the global economy? (6 marks) 30

31. Or…. 31

32. January 2006 - inflation 32

33. The questions 33