Inflation

ECO 12/4/3

Inflation

Is an increase in the general price level or average price level

This means the price of most goods and services in the economy have risen on average

Disinflation

A decrease in the rate of inflation. Note inflation is still occurring just at a lower

rate e.g. inflation falls from 5% to 2% , [Price level is still rising, but at a declining rate]

This is like a runner slowing down - they are still going forwards but at a slower speed

Deflation

Occurs when the general price level FALLS . i.e. when the change in the general price level

is negative

This is like a runner going backwards

Consumers Price Index CPI

Inflation is measured using the Consumers Price Index

A rise in the CPI [Consumer Price Index] means inflation has occurred

A rise in the CPI by a lesser amount means disinflation has occurred

A fall in the CPI means deflation has occurred

Purchasing Power

How many goods and services you can buy with a set amount of money

Inflation reduces the purchasing power of money e.g. $100 buys less goods and services now than it did a year ago due to inflation

Individual Price Rise versus a General Price level Rise

Individual price rise – a rise in the price of ONE good or service only

General Price Level rise – a rise in the price of most goods and services

An individual price rise of one good/service rise is not inflation as many other goods may not have changed in price, meaning the average price level won’t change.

However, a rise in the price of some goods such as petrol which is a cost of production for most firms may lead to many other goods and services rising in price.

Nominal vs Real Indicators

Nominal – is the money or face value of an indicator e.g. nominal wage is money value of your wages say $125 per week

Real – nominal values adjusted for inflation e.g real wage is the nominal wage adjusted for inflation

If your nominal wage increases by 4% and inflation is 3% then in real terms your real wage has increased by only 1%

Quantity Theory of Exchange

M x V = P x Q

M = Money SupplyV = velocity of circulation – how fast money changes hands to finance transactionsP = Price Level as measured the CPIQ = Quantity of national output

Crude Theory

Assumes that V and Q are unchanged so that increases in M lead directly to increases in P

i.e increases in the money supply lead to inflation.

M V = P Q

Sophisticated Theory

Assumes that all variables can change so increases in M lead may actually lead to increases

in Q rather than P [the increase in M is soaked up by the increased output]

M V = P Q However if the economy is near full employment it is

difficult to increase national output [Q] as nearly all resources are fully employed. In this case increases in M will lead to increases in P as Q cannot increase much, if at all.

Sophisticated Theory [cont]

A key idea of the sophisticated theory is An increase in the money supply will only be inflationary

[increase P] if the rate of growth of the money supply [M] exceeds the rate of output [Q] in the economy.

Aggregate Demand

Aggregate Demand - the quantity of output that will be purchased at a given price

level and represents the total demand in the economy. Price Level [PL]

AD Real GDP [Y]

Factors Affecting Aggregate Demand

Consumption [C] Investment [I] Government Spending [G] Export Receipts [X] Import Payments [M]

AD

C

income

direct tax/ income tax

consumer confidence

interest rates

inflationary expectations/ future prices

I

interest rates

business confidence

G

Govt spending decisions

X

exchange rate

overseas demand

overseas trade barriers

e.g. tariffs

tastes/ preferences

M

exchange rate

tastes preferences

NZ trade barriers e.g.

tariffs

Increase in Aggregate Demand

Price Level [PL]

AD1 AD

Real GDP [Y]

A decrease in aggregate demand is the opposite.

Aggregate Supply

- the quantity of national output firms are willing to supply at each general price level.

Price Level [PL] AS

Real GDP [Y]

Factors Affecting Aggregate Supply

Nominal Wage Cost of imported raw materials Productivity Indirect Taxes Technology

AS

nominal wagesImported

raw materials cost

exchange rates

overseas price

productivity

technology

skilled labour leaving NZ

Indirect Tax

GST tax

excise tax

Technology

Increase in Aggregate Supply

Price Level [PL] AS AS1

Real GDP [Y]

A decrease in aggregate supply is the opposite.

Aggregate Demand and Supply Equilibrium

Cost Push and Demand Pull Inflation

Demand Pull Inflation – any factor that increases Aggregate Demand will cause Demand Pull inflation.

Cost Push Inflation – any factor that decreases Aggregate Supply will cause Cost Push inflation

Demand Pull Inflation

Price Level [PL] AS

PL1

PLe

AD

Ye Y1 Real GDP [Y]

Demand pull inflation is shown by the increase in price level from PLe to PL1

AD1

Cost Push Inflation

Price Level [PL] AS1 AS

PL1

PLe

AD

Y1 Ye Real GDP [Y]

Cost Push inflation is shown by the increase in price level from PLe to PL1

THE BUSINESS OR TRADE CYCLE

All economies have cycles of economic activity with periods of strong growth [booms] being followed by periods of low growth [recession].

These fluctuations are caused by changes in aggregate [overall] demand in the economy.

The Trade or Business Cycle

The Trade or Business Cycle

Recession [or Downturn] a period of lower economic growth [i.e. falling real GDP or low increases in real GDP] demand for goods and services is falling employment is falling, unemployment rising incomes are not rising as quickly prices are likely to rising less quickly [disinflation].

The official definition of a recession is real GDP falling for two consecutive quarters.

The Trade or Business Cycle

Trough a period of very low or negative economic growth demand for goods and services is very low employment is at low levels, unemployment high incomes are not rising prices are unlikely to rise or possibly fall

[deflation]

[A severe or extreme trough is called a depression]

The Trade or Business Cycle

Recovery a period of rising economic growth

[i.e. rising real GDP] demand for goods and services is rising employment starts to rise, unemployment

falls incomes rising prices start to rise [called inflation].

The Trade or Business Cycle

Boom a period of high economic growth

[i.e significant increases in real GDP] demand for goods and services is very high employment is near or at its maximum,

unemployment is very low prices may also be rising rapidly as extra demand for

output encourages firms to raise their prices. [higher inflation]

Impacts of Inflation on Households

Savings: LOSE Inflation creates a disincentive to save, people are more

likely to spend money now before prices increases Inflation erodes the real value of savings i.e. your savings

buy less goods and services than they did before. [Note: interest rates compensate for this but your real return is still reduced e.g. if interest rate on savings is 6% then your savings are increasing in value by 6% but if inflation is 4% then your savings are decreasing in value by 4%. Overall your real return is 2%]

Impacts of Inflation on Households

Borrowers: WIN Inflation creates an incentive to borrow as borrowers

pay back less in real terms i.e. the dollars which are repaid buy less goods and services than before .

As assets increase in price during times of inflation people can borrow more against the asset i.e. if banks let you borrow 80% of the value of your home then if the value of your home increases then you can borrow more money.

Impacts of Inflation on Households

Borrowers: WIN [continued] Leverage - the amount borrowed as a percentage of

the value of an asset falls if the asset increases in price/value due to inflation e.g. buy a house for $500 000 and borrow $400 000 to finance it [ loan = 80% of the house value]. Over the next 5 years The value of the house rises to $600 000 due to inflation. The original amount of the loan is now only 66.67% of the house value

Impacts of Inflation on Households

Fiscal Drag: LOSE As people’s income tend to increase during inflation

they move into a higher marginal income tax bracket.

Planning/Budgeting: LOSE More difficult to budget for day to day living

expenses or plan ahead to buy assets such as houses because it is more difficult to know what prices will be in the future.

Impacts of Inflation on HouseholdsFixed Income Earners: LOSE Their income falls in real terms i.e their income stays

the same as prices rise so their income buys less.This especially affects those people on benefits such as the unemployment benefit or superannuation.

Incomes that rise faster than inflation: WIN Those people who get paid commission based on the

value of what they sell may find their income increases as prices/values increase. Also people whose skills are in high demand or who are members of strong unions may be able to demand larger pay increases.

Impacts of Inflation on Households

Holders of Real Wealth: WIN The value of assets such as houses tends to keep

pace or rise more than the inflation rate.

Impacts of Inflation on Firms

Factor Costs: LOSE Inflation forces up firm’s production costs. This may

reduce profit especially if the firm is in a competitive market where they may lose sales if they increase prices [to compensate for increased costs.]

Impacts of Inflation on Firms

Investment LOSE Inflation causes prices of factories, machinery and

vehicles etc. to rise so it is more expensive for firms to expand.

Inflation causes business confidence to fall and discourages investment as higher returns are needed to compensate for inflation and so investment is

seen as a higher risk.

Impacts of Inflation on Firms

Planning: LOSE Makes planning more difficult as future costs and

prices are harder to predict if they are increasing.

Financing/Borrowing: WINsimilar to households Inflation encourages debt as the amount you have to

pay back falls in real terms Can borrow more against value of firm’s assets Leverage – loans as a percentage of assets falls.

Impacts of Inflation on FirmsSpeculation: Businesses are more likely to speculate on non

productive assets that are likely to increase in price quickly during times of inflation e.g. buying sections of land

Inflated Results: LOSE Business revenue and profits may rise simply because

firms have increased their prices. This may mislead businesses into that they are performing better when in actual fact their “real sales” are the same or worse.

Impacts of Inflation on FirmsExporters: LOSE If NZ’s inflation rate is higher than other

countries we trade with then the cost of producing goods in NZ rises more than the cost of producing overseas. Exporters can either increase prices which means NZ exports are less price competitive overseas leading to less sales or they may decide to leave overseas price unchanged and take a cut in profits in order to remain competitive.

Impacts of Inflation on Firms

Importers: WIN Imports become more price competitive. If

NZ’s inflation rate is higher than other countries we trade with then the price of imported goods rises less than the price of NZ goods so they become more price competitive.

Impact of Inflation on Government

Government Spending e.g. Rising costs/prices means Govt. will have to spend more on

health, education, police etc. Beneficiaries may demand benefit increases to offset the the

fall in real income/purchasing power.

Government Income e.g. Increased spending due to higher prices/inflationary

expectations will increase GST revenue. Rising incomes will mean more people in higher income tax

brackets so more income tax revenue.

Impact of Inflation on Government

Operating Balance Increased Government spending has a negative

effect on the operating balance Increased tax take through GST and income tax will

have a positive effect on the Government operating balance

Overall effect of inflation on the operating balance depends if the positive effect of increased tax is greater or less than the negative effect of increased spending.