8. Economic Problems: Inflation

8. Economic Problems: Inflation

1. Definition of inflation: An economic situation where there is a sustained increase in e general price level of an economy.

   • Anticipated inflation--Majority of individuals believe e inflation will occur
   • Unanticipated Inflation--Comes as a surprise, economic agents unprepared

2. Inflation rate= % change in e relevant px index btn any 2 periods of time

   • [(Px index in yr 2 - Px index in yr 1) / Px index in yr 1] X 100%
     • Rise in inflation rate= Faster rate of px increase
     • Fall in inflation rate= disinflation= slower rate of px increase

3. Degree of inflation

   • Mild inflation: less than 2%; Desirable, may stimulate economic expansion
   • Intermediate: creeping inflation
   • Hyperinflation/ Galloping/Runaway Inflation: more than 100%; Undesirable, leads to social instability & disruptions in economy

4. Types & Causes of inflation

   • Demand-pull inflation: occurs when there are persistent rises in AD in e economy not matched by output of goods & services (AS)
     • Causes of dd pull inflation: determinants of C, I, and X
       • Px Adjustment process: increase in AD, resources (FOP) become increasingly limited, shortage arise. Firms compete for resources by offering higher px, hence dd higher px for pdt
   • Cost-push inflation: persistent rises in costs of production, indep of AD
     • Sources of cost-push inflation (SRAS)
       • wage-push inflation
       • import px-push inflation
       • tax-push inflation
       • Px adjustment process: increase COP, firms cut back on production, shortage of output at original px level, GPL increase
     • Cause (LRAS): consistent depletion of natural resources
       • reduces potential output
       • resource become scarcer, firms pay more to secure these resources

5. Wage Price Spiral: an effect of inflation, whereby inflation can breed more inflation (regardless of e initial type). As trade union dd for higher wage continues, it leads to higher GPL.

   • Increase in GPL, trade unions dd higher wages for members, causing higher COP for firms, reduce production, GPL increase again, trade unions ask for higher wages again

6. Effects of inflation

   • Internal effects
     • Redistribution of income
       • Debtors (borrowers) vs creditors (lenders); debtors gain if i/r lower than inflation rate
       • Fixed vs variable income earners
       • Businessmen vs labour; profits for businessmen rise faster than costs as px rise faster than costs
       • Real vs nominal saving; ppl tend to spend & not hold cash to avoid further loss (C rise, saving fall)
     • Loss of confidence in currency
       • Real value of currency falls; Preference to trade in real asset, save less in terms of currency in bank, less funds for banks to lend firms for I
     • Effect on investment
       • uncertainty in planning future profits & costs, lower level of planned capital investment, detrimental to LR-EG
     • Effect on government finance
       • Real cost of borrowing by selling govt bonds to public reduced
         • i/r on bond is fixed at time of issue
       • Tax revenue increase
         • Budget surplus if govt revenue > expenditure
       • short-lived benefits, cant outweigh costs imposed on society & economy
     • Effect on production
       • Input px rise faster than product px
         • business earn lower profit, firms forced to become more efficient to survive
       • Product px rise faster than input px
         • high expected returns, may reduce efficiency in production bc high px brings high profits
       • In periods of high inflation, producers cannot differentiate btn px change due to inflationary pressure or increase in genuine dd; misallocate resources
   • External effects
     • Effect on balance of payment (deteriorate) & external value of currency (falls) as more currency flow out than into e economy
     • Effect on capital balance: short term capital inflow (due to foreigners transferring more funds into domestic country to take advantage of higher i/r) + long run capital outflow (due to fall in FDI, domestic country seen less attractive & economically unstable)
     • Effect on balance of trade (current balance): deteriorate as net exports falls as imports become a cheaper substitute

7. Remedies for inflation (see another mindmap)

8. Deflation: Persistent decrease in GPL

   • Due to decrease in AD (potential problem as Real NY decrease)
     • tight MP in response to inflationary pressure
     • increased savings
   • Due to increase in AS (positive as Real NY increase)
     • Imrprovement in technology: technological advancement
     • Deregulation of industries: imported resources may more easily & cheaply obtained due to gradual opening of markets around e world, developed import from developing economies