Economics (9708) | Price stability

Welcome to Chapter 4.6: Price Stability!

Hello future economist! This chapter is incredibly important because it deals with one of the government's main macroeconomic goals: keeping prices stable. Price stability doesn't mean prices never change, but rather that the overall average price level in the economy remains predictable and manageable.

Why should you care? Because inflation and deflation affect your wallet, your savings, your future job prospects, and everything a government plans. Understanding this topic is key to mastering macroeconomics!

1. Defining Price Changes (4.6.1)

When we talk about price stability, we need three key definitions. Don't worry if they sound similar—we’ll break down the differences.

A. Inflation

Inflation is defined as the sustained increase in the general price level of goods and services in an economy over a period of time.

• What it means: Your money buys less than it did before. The purchasing power of money decreases.
• Analogy: Think of inflation as a balloon being continuously inflated. The economy is overheating and prices are expanding.

B. Deflation

Deflation is the sustained decrease in the general price level of goods and services.

• What it means: Prices are falling, and the purchasing power of money is increasing.
• Did you know? While falling prices sound good for consumers, widespread deflation is generally feared by governments because it often signals a deep economic slump. Why? Consumers delay buying (waiting for prices to fall further), slowing down production.

C. Disinflation

Disinflation is a decrease in the rate of inflation. Prices are still rising, but they are rising more slowly than before.

• Example: If inflation was 10% last year, and this year it is 3%, the economy is experiencing disinflation (prices are still going up by 3%, but the rate of increase has dropped).

2. Measuring Changes in the Price Level (4.6.2)

A. The Consumer Price Index (CPI)

The most common way governments measure changes in the price level is using the Consumer Price Index (CPI).

The CPI measures the changes in the average price of a standard fixed basket of goods and services purchased by the typical household.

How the CPI is calculated (Step-by-Step)

1. Create the Basket: Economic surveys (like the Household Expenditure Survey) determine what the average family buys (e.g., bread, rent, petrol, clothing, phone bills).
2. Weight the Items: Items that take up a larger proportion of household spending (like housing or transport) are given a higher weight in the index.
3. Establish a Base Year: A specific year is chosen, and its index value is set to 100.
4. Track Prices: Prices of all items in the basket are tracked over time.
5. Calculate Inflation: The percentage change in the CPI from one period to the next shows the rate of inflation.
   \(\text{Inflation Rate} = \frac{\text{CPI}_{\text{Current}} - \text{CPI}_{\text{Previous}}}{\text{CPI}_{\text{Previous}}} \times 100\)

B. Difficulties in Measuring the Price Level

The CPI is an estimate, and it faces several challenges that can make the measured inflation rate inaccurate:

• The Basket is Imperfect: The basket represents the average household. It may not accurately reflect the spending patterns of specific groups (e.g., retirees, very rich families, or vegetarians).
• Quality Changes: If a new laptop costs the same as last year's model, but is twice as fast, the price has technically fallen relative to the quality, but the CPI might record zero change. It’s hard to adjust for improvements in quality.
• Substitution Bias: When the price of Item A rises significantly (e.g., beef), consumers switch to cheaper Item B (e.g., chicken). The fixed CPI basket assumes people keep buying Item A, thus overstating the true cost of living increase.
• New Products: Economists have to regularly update the basket to include new, popular goods (like streaming services or specific technological gadgets), but incorporating them takes time, leading to inaccuracies.

Key Takeaway: CPI is the standard measure of inflation, calculated based on a weighted average of typical consumer goods, but it suffers from issues related to quality, substitution, and relevance.

3. Nominal vs. Real Values (4.6.3)

This is a critical distinction in macroeconomics. Whenever you see data adjusted for inflation, it is referred to as "real."

A. Nominal Values (Money Values)

Nominal values (or money values) are the values expressed in current monetary terms. This is the figure you see on your paycheque or in your bank account.

• Example: If your salary is $50,000, your nominal income is $50,000.

B. Real Values

Real values are figures adjusted to remove the effects of inflation. They reflect the actual purchasing power of the money.

• Example: If your nominal salary increases by 5%, but inflation is 8%, your real income has actually decreased by 3% because your money buys less.

The relationship is simple:
Real Value = Nominal Value / Price Index

The Shopping Cart Analogy: If your salary (Nominal Value) increases, but the cost of filling your shopping cart (Price Level) increases even faster, then the size of your cart (Real Value/Purchasing Power) is shrinking.

Key Takeaway: Always use real data when comparing economic performance over time, as it is the only measure that tells you if people are actually better or worse off.

4. Causes of Inflation (4.6.4)

Inflation is broadly categorised into two main types based on what is driving the increase in the price level: demand or supply (costs).

A. Demand-Pull Inflation

Demand-Pull Inflation occurs when Aggregate Demand (AD) grows faster than the economy's ability to produce goods and services (Aggregate Supply). It is often described as "too much money chasing too few goods."

• The AD/AS Model: An increase in AD (a rightward shift of the AD curve) leads to a higher equilibrium price level and higher real output, but once the economy hits full capacity, output cannot increase further, and prices rise rapidly.

Sources of Increased Aggregate Demand (AD)

Remember, AD = C + I + G + (X – M). Anything that strongly increases these components can cause demand-pull inflation:

1. Higher Consumption (C): If taxes are cut or interest rates fall, consumers borrow and spend more.
2. Higher Investment (I): Firms invest more heavily in anticipation of future growth.
3. Higher Government Spending (G): The government funds large infrastructure projects or increases public sector wages.
4. Strong Export Growth (X): Overseas demand for domestic goods surges.

B. Cost-Push Inflation

Cost-Push Inflation occurs when the costs of production for firms increase, causing them to raise prices to maintain profit margins. This reduces the economy's willingness and ability to supply goods.

• The AD/AS Model: A decrease in Short-Run Aggregate Supply (SRAS) (a leftward shift of the SRAS curve) leads to a higher equilibrium price level and lower real output (this is known as stagflation).

Sources of Increased Costs of Production

1. Wage-Push Inflation: Powerful trade unions successfully negotiate high wage increases that are not matched by productivity improvements.
2. Imported Inflation: If the price of critical imported raw materials (like oil or grain) increases globally, or if the country's currency depreciates (making imports more expensive), costs rise for domestic firms.
3. Tax Increases: Higher indirect taxes (like VAT or GST) increase the costs borne by firms, which are often passed on to consumers.
4. Natural Disasters/Supply Shocks: Events that physically disrupt production (e.g., floods destroying crops or factories).

Key Takeaway: Inflation is caused either by a surge in overall spending (Demand-Pull) or by a squeeze on production capacity due to higher costs (Cost-Push).

5. Consequences of Inflation (4.6.5)

While a small, predictable rate of inflation (often 2-3%) is considered healthy, high or volatile inflation can cause significant damage to the economy.

A. Negative Consequences of High/Uncertain Inflation

• Redistribution of Income and Wealth: Inflation acts as a hidden tax.
  • It harms people on fixed incomes (e.g., pensioners) whose real purchasing power falls.
  • It benefits debtors (borrowers) and harms creditors (savers/lenders) because the money paid back is worth less in real terms.
• Uncertainty: High inflation makes it difficult for firms to plan future investment and costs, leading to reduced capital investment and slower long-run growth.
• Loss of International Competitiveness: If a country’s inflation rate is higher than its trading partners', its exports become relatively more expensive, leading to a fall in the current account balance (X-M).
• "Shoe-Leather Costs": This refers to the time and effort spent minimizing the cash holdings that are losing value (e.g., frequent trips to the bank). This is a waste of resources.
• "Menu Costs": The physical costs to firms of constantly having to update price lists, menus, labels, and vending machines.
• Wage-Price Spiral: Workers demand higher wages to compensate for rising prices (inflation). Firms raise prices to cover these higher wages, leading to even more inflation, creating a continuous upward spiral.

B. Consequences of Deflation (for contrast)

Deflation, although seemingly good, has its own severe problems:

• Consumption Delay: Consumers postpone purchases, expecting prices to fall further, leading to a massive drop in AD.
• Increased Real Debt Burden: As prices and incomes fall, the real value of debts (like mortgages) increases, potentially leading to loan defaults and banking crises.
• Business Losses: Falling prices squeeze profit margins, forcing firms to cut production, leading to higher unemployment.

C. Benefits of Low, Stable Inflation

A low, stable rate of inflation (e.g., 2%) is generally considered beneficial:

• It prevents the dangers of deflation.
• It gives firms and workers the confidence to plan and invest, as price changes are predictable.
• It allows for easier wage adjustments in the labour market (firms can keep nominal wages stable, but let real wages fall slightly via inflation, avoiding actual wage cuts which workers resist).

Key Takeaway: Unpredictable inflation (or deflation) creates uncertainty, redistributes wealth unfairly, and damages a nation's trade balance. Stability is the macroeconomic goal.