Welcome to Inflation & Deflation!
Hey everyone! Ever wonder why the price of your favourite bubble tea or lunch box seems to go up over time? Or why your parents talk about how much cheaper things were "back in their day"? The answers lie in the concepts of inflation and deflation.
This is a super important topic because it affects everyone's money – from your personal savings to the entire Hong Kong economy. Don't worry, we'll break it down into simple, easy-to-understand parts. Let's get started!
1. Defining Our Key Terms
First things first, let's get our main definitions straight.
What is Inflation?
In simple terms, inflation is when prices for most goods and services are rising. The formal definition is:
Inflation is a sustained increase in the general price level.
Let's break that down:
- Sustained increase: This isn't a one-time price jump. The prices have to keep rising over a period of time (e.g., month after month).
- General price level: This means it's not just one or two items getting more expensive. It's a broad increase in the average price of many goods and services across the economy, like food, transport, housing, and entertainment.
Analogy: Think of your money's buying power like a phone battery. Inflation slowly drains that battery. The same $50 buys you a little less today than it did last year.
What is Deflation?
Deflation is the exact opposite.
Deflation is a sustained decrease in the general price level.
This is when the average price of goods and services is continuously falling. While falling prices might sound great, it can actually be a big problem for the economy, but we'll get into the effects later!
Quick Review: Key Definitions
Inflation = Sustained RISE in general price level.
Deflation = Sustained FALL in general price level.
Common Mistake to Avoid!
A common mistake is thinking that if the price of iPhones goes up, it's inflation. Not necessarily! Inflation is about the average price of a whole basket of goods and services rising, not just a single product.
Key Takeaway for Section 1
Inflation and deflation describe the direction of the economy's average price level over time. Inflation means your money buys less, while deflation means it buys more.
2. Nominal vs. Real Interest Rates: What's the Difference?
When we talk about inflation, the interest rates you see at the bank don't tell the whole story. We need to distinguish between what's written on paper (nominal) and what it means for your actual purchasing power (real).
What are Nominal and Real Interest Rates?
- Nominal Interest Rate: This is the interest rate as advertised by a bank. It's the rate of growth of your money in dollar terms. If you put $100 in an account with a 5% nominal interest rate, you'll have $105 in one year. Simple!
- Real Interest Rate: This is the interest rate after accounting for inflation. It tells you the rate of growth of your purchasing power. It answers the question: "How much *more stuff* can I actually buy?"
The All-Important Formula
The relationship between them is given by a simple formula. The syllabus expects you to know this, so pay close attention!
$$ \text{Nominal Interest Rate} = \text{Real Interest Rate} + \text{Expected Inflation Rate} $$
Often, it's more useful to rearrange it to find the real interest rate:
$$ \text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Expected Inflation Rate} $$
Let's see it in action:
Example: You deposit money in a bank that offers a 4% annual interest rate (this is the nominal rate). You and the bank expect the inflation rate for the coming year to be 3%.
Your expected real interest rate is: 4% - 3% = 1%.
This means that while your money amount will grow by 4%, your ability to buy goods and services will only grow by 1%. The other 3% was 'eaten' by inflation!
Key Takeaway for Section 2
The nominal interest rate is the sticker price, but the real interest rate is what really matters for your wealth because it accounts for the effects of inflation on your purchasing power.
3. The Redistributive Effects of Unanticipated Inflation
What happens when inflation is a surprise? When it's higher or lower than what people expected, it can create unexpected winners and losers. This is called a redistributive effect – it shifts wealth from one group to another. We'll focus on unanticipated inflation (inflation that is higher than expected).
a) Debtors (Borrowers) vs. Creditors (Lenders)
Don't worry if this sounds tricky. The main idea is simple: unanticipated inflation makes the money you pay back in the future worth less.
- Debtors (Borrowers) GAIN from unanticipated inflation. Why? They borrow money when it has high purchasing power but repay the loan later with money that has lower purchasing power. In "real" terms, their debt has become cheaper to pay off.
- Creditors (Lenders) LOSE from unanticipated inflation. Why? They lend out money with high purchasing power but get paid back later with money that can't buy as much. The real return on their loan is lower than they expected.
Simple Example: David (debtor) borrows $1,000 from Carol (creditor). They both expect 0% inflation. However, the economy experiences a surprise 10% inflation over the year. When David repays the $1,000, that money can only buy what $909 could have bought a year ago. David gained, and Carol lost purchasing power.
The opposite is true for unanticipated deflation: Debtors lose because they repay with money that is worth more, and creditors gain.
b) Holders of Monetary Assets vs. Real Assets
Unanticipated inflation also affects people based on what kinds of assets they own.
- Monetary Assets are assets with a fixed money value, like cash or money in a bank account. Holders of these assets LOSE during inflation because the purchasing power of their fixed amount of money falls. Your $100 bill will still be a $100 bill, but it will buy fewer things.
- Real Assets are physical assets like property, gold, or artwork. Holders of these assets are often protected or may even GAIN during inflation. This is because the money price of these physical items tends to rise along with inflation, preserving their real value.
Did you know?
This is why people often see property as a 'hedge against inflation'. They believe the value of their apartment will increase over time, protecting their wealth from being eroded by a general rise in prices.
Key Takeaway for Section 3
Unanticipated inflation isn't fair to everyone. It redistributes wealth from creditors (lenders) and holders of monetary assets TO debtors (borrowers) and holders of real assets.
4. A Simple Theory of Inflation: The Quantity Theory of Money
So, what causes inflation? One of the oldest and simplest explanations is the Quantity Theory of Money. It connects the amount of money in an economy directly to the price level.
The Equation of Exchange
The theory starts with a famous equation called the Equation of Exchange. It looks like this:
$$ MV = PY $$
Let's break down each letter. It's easier than it looks!
- M = Money Supply: The total amount of money circulating in the economy.
- V = Velocity of Circulation: The average number of times a dollar is spent on final goods and services in a year. Think of it as how fast money is changing hands.
- P = General Price Level: An average of the current prices.
- Y = Real Output (Real GDP): The total quantity of goods and services produced in the economy.
The equation `MV = PY` simply says that the total amount of money spent (`MV`) must equal the total market value of things sold (`PY`). This equation is always true by definition.
From an Equation to a Theory
To turn this into a theory that explains inflation, we need to make some assumptions.
Assumption 1: Both V and Y are constant (unchanging).
The theory assumes that V (people's spending habits) and Y (the economy's production capacity) are stable and don't change much in the long run. If V and Y are fixed, what happens when M changes?
If `M` goes up, `P` must go up by the same percentage to keep the equation balanced.
Conclusion: Under these assumptions, the price level is directly proportional to the money supply. If the government doubles the money supply (M), the price level (P) will also double.
Example: If the money supply (M) increases by 8% and V and Y are constant, the inflation rate will be 8%.
Assumption 2: Only V is constant.
This is a more flexible assumption. We still assume spending habits (V) are stable, but we allow the economy's output (Y) to grow. The relationship can be shown in percentage change form:
$$ \% \Delta P = \% \Delta M - \% \Delta Y $$ (Where %ΔP is the inflation rate)
This says that the inflation rate is the growth rate of the money supply MINUS the growth rate of real output.
Conclusion: Inflation occurs when the money supply grows faster than the economy's ability to produce goods and services. It's the classic idea of "too much money chasing too few goods".
Example: If the money supply (M) grows by 10% in a year, and real output (Y) only grows by 4%, the inflation rate will be: 10% - 4% = 6%.
Key Takeaway for Section 4
The Quantity Theory of Money proposes a direct link between the money supply and the price level. In its simplest form, if the amount of money in the economy grows faster than the amount of goods and services being produced, prices will rise, causing inflation.