Inflation and Deflation

How do we define inflation?

“A continuing increase in the general price level”. But let’s focus on some key words in the definition

Inflation defined….

Continuing means the increase must be occurring over a period of time, not just a

one time increaseIncrease refers to the rising price level of

goods and services on average, not every good and service in the economy

General price level is an average of prices of goods and services in the entire

economy

How do we define deflation?

“A continuing decrease in the general price level”. (the same descriptions

apply here as in the definition of inflation)

How are inflation and deflation expressed?

As a percentage change of the general price level that has occurred over the

course of a year (although shorter time periods are also calculated).

Inflation is much more commonly seen than deflation

Changes in the price level vs. changes in rate of

inflation Consider this: In one year we have an

increase in the general price level of 5%, followed the next year by an

increase in the general price level of 7%.

What can we say is happening to the price level and inflation rate in both

years?

Changes in the price level vs. changes in rate of

inflation Now assume we have an increase in the general price level of 10%, followed

the next year by an increase in the general price level of 7%.

What can we say is happening to the price level?

What can we say about the rate of inflation?

Causes of inflation

There are three causes of inflation. Can you recall any or all of these?

Demand-pull inflation

This type of inflation is caused by increases in AD which move the

economy beyond the equilibrium level of real GDP and the equilibrium price

level. Demand-pull inflation is associated

with an inflationary gap, and the unemployment rate falls below the

natural rate of unemployment.

Demand-pull inflation

How to deal with demand-pull inflation?Simple, just reduce AD by enacting contractionary fiscal policy or “tight-

money” monetary policy. This should bring the AD curve back to

the equilibrium level of real GDP and lower the average price level.

Cost-push inflation

This type of inflation is caused by increases in costs of production which

move the economy below the equilibrium level of real GDP and above

the equilibrium price level. You can also think of this as the

negative supply-shock phenomenon as input costs rise and firms supply less

output.

Cost-push inflation

How to deal with cost-push inflation?

It depends. If increasing wage rates are the root of the problem, the supply-

side folks have lots of ideas.If the problem is caused by increasing

commodity prices (like oil), efforts to reduce oil consumption could lead to lower prices, as demand for oil falls, but this won’t happen overnight…

More sources of cost-push inflation

Monopolies and/or oligopolies may behave in a manner as to increase prices to raise profits. Supply-side

policies to dismantle these firms may be in order.

More sources of cost-push inflation

A depreciating domestic currency may increase input costs for firms if they

use foreign goods in production. Efforts to reduce reliance on imports

could solve this problem.

Excessive growth in the money supply

Monetarists argue that changes in the money supply affect the general price

level. They use the quantity equation on the

next slide to express their views…

Quantity Equation

M X V = P X QWhere M = money supply

V= velocity of money (or circulation)P = price

Q = quantity of output

M X V = P X Q

M X V = total spending in the economyP X Q = nominal value of GDP

Because total spending and the value of GDP are equal as we learned when

discussing the three methods of calculating GDP, the equation is true.

Now let’s go further…

M X V = P X Q

Monetarists make two assumptions: V is stable over short periods of time

Q is determined by quantity and quality of factors of production, not the

supply of money or the price levelSo any change in M will directly affect

P

Inflation due to increase in money supply

Inflation due to increase in money supply

Monetarists argue that increasing the money supply (M) will shift AD to the right as C and I spending increase.

In the short-run, output increases and price level does too, but in the long-run, output returns to the equilibrium level and all we have is a higher price

level (P)

Monetarists believe:

The long-run happens quickly, so gains in output are short-lived

Demand-side policies can’t increase real GDP in the long-run

In benchmarks for increasing money supply (GDP grows by 3%, increase the

money supply by 3%)

Last word on monetarism

The monetarist conclusions are subject to debate. Their conclusions about the

relationship b/w money supply and inflation holds in the long-run, but not

so much in the short-runOne thing is clear, if you want

hyperinflation, you must increase the money supply!

Costs of inflation

One cost is the loss of purchasing power. If your income remains

constant and the general price level rises, your purchasing power has

decreased. You can no longer buy the same quantity of goods if the price level is

increasing more rapidly than your real income

Costs of inflation

Inflation redistributes income from one group to another. If you have a fixed

income and the inflation rate begins to rise, you end up with less money than

before. Who fits in this category?

Fixed income folks

Workers with fixed wage contractsPensionersLandlords

Welfare recipients

Other Inflation losers

Holders of cashPeople who save moneyPeople who lend money

Inflation Winners

BorrowersPayers of fixed incomes or wages

Other Inflation Problems

Firms get antsy when it is difficult to predict what is happening with the general price level. They may be

unwilling to invest in new capital goods if they fear customers may lose purchasing power in the future.

This general level of uncertainty may slow economic growth.

Other Inflation Problems

Menu costs suggest that firms will incur large printing costs as the general

price level fluctuates. Sounds silly, but this can still be a real

expense for a firm if they have to constantly redo their pricing lists.

Other Inflation Problems

A “money illusion” may fool people into thinking they are doing better than

they really are. If you get a 10% raise at work, but the

inflation rate is 15%, you are obviously worse off, but if you are not paying close attention to the general price level, you might make some foolish

spending decisions

Other Inflation Problems

If a country is experiencing inflation, it’s exports become more expensive to

foreign nations and imports become cheaper than domestically produced

goods.This can severely disrupt a country’s

trade position and balance of payments

Hyperinflation

Inflation gone wild. If the price level increases by 50% a month, you have

hyperinflation. An inflationary spiral results and a

massive disruption of economic activity occurs. The barter system may take over and significant social problems

often follow

Causes of deflation

Deflation is a very rare occurrence for several reasons:

Worker’s wages rarely fall, so firms tend to not lower the price of the goods

they sellOligopolies abhor price warsFirms try to avoid menu costs

Causes of deflation

Decreases in AD may eventually lead to a decrease in the general price level.

Unfortunately, recession often accompanies this change, as do falling incomes and output, as well as cyclical

unemployment. This is what happened during the Great

Depression of the 1930s.

Decreasing AD

How to deal with less AD?

Obviously expansionary fiscal policy and “easy” monetary policy would be in order to shift the AD curve back to

the original position

Increases in AS

The “good” deflation may occur when the AS curve shifts to the right, thus

lowering the average price level while output increases.

Economic expansion, rising incomes and output, increasing employment and economic growth may all occur.

Costs of deflation

Redistribution of income (opposite as during inflation)

Uncertainty for firms may lead to lack of investment

Menu costs again…..A deflationary spiral may result as borrowers

are discouraged from taking loans, and spending slows by consumers as they expect prices to continue to fall and AD continues to

fall….

Add it all up….

With deflation, the real value of debt rises, the economy is in recession,

incomes are falling and bankruptcies result as borrowers are unable to pay

back loans. A major financial crisis could easily

occur.