Economics (9640) Study Notes: Inflation and Deflation (3.2.3.3)

Welcome to the chapter on price stability! This is one of the four main objectives of macroeconomic policy (alongside growth, low unemployment, and stable Balance of Payments). Understanding inflation and deflation isn't just about knowing definitions; it's crucial for understanding how governments manage the economy and protect the value of your money.

Don't worry if the different types of inflation sound confusing at first. We will break them down using simple economic models!

1. Defining Price Stability: Inflation, Deflation, and Disinflation

Price stability is generally achieved when the price level is rising slowly and predictably (often around 2%). When prices deviate significantly, we run into problems.

Key Definitions

Inflation is the sustained or general rise in the average price level in an economy over a period of time.
Analogy: Imagine a shopping basket of goods costing £100 this year. If inflation is 5%, that same basket costs £105 next year.

Deflation is the sustained or general fall in the average price level in an economy over a period of time.

Disinflation is when the rate of inflation is falling, but the price level is still rising.
Example: If inflation was 8% last year, and is 3% this year, the country is experiencing disinflation. Prices are still going up (by 3%), but much slower than before.

Quick Review Trick:

  • INflation: Prices go INcreasingly up.
  • DEflation: Prices go DEcreasingly down.
  • DISinflation: The problem (the rate) is DISappearing, but prices are still rising.

2. Causes of Inflation: The AD/AS Model

Inflation is typically explained using the Aggregate Demand (AD) and Aggregate Supply (AS) framework. Remember, AD is the total spending in the economy: \(AD = C + I + G + (X - M)\).

2.1. Demand-Pull Inflation

This occurs when Aggregate Demand (AD) rises faster than the economy's ability to produce goods and services (Aggregate Supply). Essentially, there is "too much money chasing too few goods."

When AD shifts right (especially close to or beyond the full capacity of the economy), businesses respond to the high demand by increasing prices rather than output, leading to inflationary pressure.

  • Causes of Rising AD (Shifts Right): Higher consumer confidence leading to more Consumption (C), lower interest rates encouraging Investment (I), increased Government spending (G), or a rise in Net Exports (X-M).
  • Analogy: Demand-Pull is like a popular auction. If many people want the same limited item (a house, for example), they bid up the price, even if the item itself hasn't changed.
2.2. Cost-Push Inflation

This occurs when firms face rising costs of production, forcing them to raise their prices to maintain their profit margins. This is represented by a leftward shift of the Short-Run Aggregate Supply (SRAS) curve.

This is often seen as a more damaging type of inflation because it leads to higher prices and lower output (a fall in Real GDP).

  • Causes of Rising Costs (Shifts SRAS Left):
    • Money Wage Rates: Strong trade unions or a tight labour market might push wages up faster than productivity.
    • Raw Material Prices: Increases in global commodity prices (like oil or copper) raise input costs for many industries.
    • Indirect Taxes: Government increases VAT or excise duties, raising the final price consumers pay.
    • Lower Productivity: If workers become less efficient, the cost per unit of output rises.
  • Analogy: Cost-Push is like a bakery raising the price of bread because the price of flour, sugar, and electricity (inputs) has dramatically increased.

Key Takeaway for Section 2: Demand-pull is generally associated with too much spending; Cost-push is associated with rising production expenses.

3. External and Monetary Influences on Inflation

In today's globalised world, domestic prices are heavily influenced by events happening overseas and decisions regarding the money supply.

3.1. External Events and World Commodity Prices

Changes in world commodity prices directly affect domestic inflation, primarily through cost-push mechanisms.

  • Example: If the global price of crude oil rises (perhaps due to geopolitical conflict), all domestic businesses that rely on fuel for transportation or production (like airlines, logistics, and manufacturing) will face higher costs. These costs are then passed on to consumers, causing inflation.
  • Food prices are another major source. A global drought could severely limit the supply of crops, increasing import costs for food-dependent nations, leading to domestic inflation.
3.2. Exchange Rate Changes and Inflation

The value of a country's currency (the exchange rate) has a significant impact on its price level.

  • Exchange Rate Depreciation (Currency Weakens):

    When the currency falls in value (e.g., £1 buys fewer Euros), imports become more expensive in domestic currency terms. This is a form of cost-push inflation, often called imported inflation. Additionally, exports become cheaper abroad, boosting demand (X increases), potentially adding demand-pull pressure.

  • Exchange Rate Appreciation (Currency Strengthens):

    When the currency rises, imports become cheaper, lowering the costs of raw materials and finished goods. This helps to reduce inflationary pressure (or combat cost-push inflation).

Did You Know? A large proportion of the goods we buy, from electronics to clothing, are imported. When your currency weakens, you need more of it to buy the same imported item, which is why exchange rates are a major factor in inflation figures.

3.3. Excessive Growth in the Money Supply

The syllabus highlights that excessive growth in the money supply will increase aggregate demand and cause inflation. This links to the classical Quantity Theory of Money.

  • If the amount of money circulating in the economy grows much faster than the number of goods and services being produced, people have more cash but nothing extra to buy.
  • Result: People bid up the prices of the existing goods. This leads to demand-pull inflation.

4. Understanding Deflationary Policies

When governments or central banks try to tackle inflation, they implement deflationary policies. These are policies designed to reduce the rate of inflation, primarily by reducing Aggregate Demand (AD).

  • Examples of Deflationary Policies: Raising interest rates (Monetary Policy), or cutting government spending and raising taxes (Fiscal Policy).

Important Syllabus Point: Students should appreciate that deflationary policies are policies to reduce aggregate demand and do not necessarily result in deflation.

Why is this distinction important?

  • Most modern economies aim for low, stable inflation (disinflation), not actual price level falls (deflation).
  • Policies usually aim to slow down the rate of price increases (to combat inflation), not reverse them entirely.
  • If the economy is growing strongly, AD policies might only slow the growth of AD down to match the growth of LRAS, achieving price stability (disinflation) without causing a recession or actual deflation.

Summary: Quick Review Box

Key Concepts to Master (3.2.3.3)

Inflation: General rise in prices.
Deflation: General fall in prices (often very dangerous for the economy).
Disinflation: Inflation rate is slowing down.
Demand-Pull: AD shifts right (too much spending).
Cost-Push: SRAS shifts left (rising input costs like wages or oil).
External Factors: Global commodity prices (Cost-Push) and Exchange Rates (Depreciation causes imported inflation).