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IB Diploma Economics:
Low and stable rate of inflation
The meaning of inflation, disinflation and deflation:
Low and stable inflation
One of the key macroeconomic objectives of government is to maintain a low and stable rate of inflation.
Inflation is a sustained increase in the general price level (average prices in an economy). When an economy is experiencing inflation, the price of goods and service in an economy will rise, on average, over time.
A price level is the current weighted average price of a representative selected group of goods and services (such as that found in the consumer price index or CPI) produced in an economy in a specified period of time (typically one year).
Inflation, deflation and disinflation
Inflation is a general increase in the price level. The price level represents the prices of most products in an economy. Thus, the prices of most products are increasing during periods of inflation. The forces of supply and demand still determine prices in individual markets. Yet, inflation creates a tendency for prices to rise throughout the economy.
The inflation rate measures how quickly the price level changes. It is usually reported on an annual basis. In October 2003, for example, the inflation rate was 2.04%. This means that if prices rose at this same rate for an entire year, then they would be 2.04% higher on October 1, 2004 than they were on October 1, 2003. (The price index was actually 0.17% higher on October 31, 2003 than it was on October 1, 2003. Twelve months multiplied by 0.17% yields an annual rate of 2.04% per year.)
Deflation is a general decrease in the price level. During periods of deflation, the prices of most products are decreasing. Deflation is undesirable because it usually causes a significant decrease in overall spending (i.e., aggregate demand) in an economy and is most likely to occur when the economy is already stagnant. For example, deflation occurred in the United States during the Great Depression. Deflation occurs when the inflation rate is negative.
Disinflation occurs when the inflation rate decreases, but remains positive. For example, if the inflation rate changes from 6% in January to 5.5% in February to 5.2% in March, economists would say there is disinflation in the economy during the first quarter of the year (i.e., during January, February and March).
Essential statement: Inflation is a sustained increase in the price level (e.g., +2%), deflation is a decrease in the price level (e.g., -1.3%), and disinflation is a decrease in the rate of inflation (e.g., from 3% to 1.7%)
What is inflation?
What is a price level?
what is Deflation?
Inflation is a sustained increase in the general price level (average prices in an economy). The price level is measured by a price index.
A price index is a data base that tracks and measures relative price changes to a weighted basket of representative goods and services over time. The more of a product that consumers or producers purchase, the greater its influence on the final price index.
For example, increases in the average prices of milk, bread, eggs and petrol will have a far greater effect on the consumer price index (CPI) than a similar increase in the price of textbook s would. This is because a far greater proportion of the average consumer income is spent on grocery staples. Any increases in the price of grocery staples will impact households more, on average, than a rise in the price of textbooks.
Similarly, increases in the prices of petrol, plastics, wages, electricity, etc. are going to have a far greater effect on firms in an economy, than increases in the prices of milk, bread and eggs. Thus, such items are heavily weighted in the producer price index (PPI), which measures price level changes from the point of view of firms.
The consumer price index is updated and the basket of good will change to reflect changes in the purchasing habits of consumers in the average household. For example, landlines and CDs (compact discs) have far less weighting in the CPI now than these particular goods had back in the 1990s. The CPI is the standard method to measure inflation, and it means that when the inflation rate is calculated, it is the inflation rate that the average household in an economy is experiencing.
The prices of some goods and services in a price index will increase and others will decrease, however, if on average, there is an overall increase in the price of an average, weighted basket of goods – there is inflation.
Essential statement: The rate of inflation is calculated from a base year, which is a specific year chosen by the government to measure changes in the weighted prices of a basket of goods from that particular point of time to another
The consumer price index
The CPI explained
Calculating a simple CPI with an unweighted basket of goods
Calculating a simple CPI when the basket of goods and services are not weighted:
An average household will spend more of its income on rent and electricity charges than it would on cut flowers and chocolates.
To better measure the impact of price changes on the average household it is useful to “weight” the price index for the proportion of income that the average household spends on each type of goods or services.
Essential statement: The government categorises the goods and services in the CPI basket of goods, and it then assigns each category a weight by calculating the average proportion of a households income is spent within each category.
Using the data in Table 2 above we can calculate the rate of inflation:
Essential statement: The CPI is constructed for the average household. In each category, the proportion of household income spent is different, and thus, each household will experience a different rate of inflation.
Limitations of the CPI
There are various limitations of the consumer price index as a measure of inflation, these include the following:
Items are added to the consumer price index when households begin to purchase them in significant quantities, and removed from the CPI when they no longer form a significant part of household expenditure. Click on the picture link below to see examples of items that have been added or removed.
Inflation in the bad old days
For much of the 70s inflation was bad. Prices rose at over 10 percent a year. Nothing could stop it. President Gerald Ford tried to cut inflation by asking Americans to spend less.
THE COST OF PARENTING over time
How much is a tooth worth to the tooth fairy and has that price changed over time? This is a silly question of course, but the answer is serious. It gives us a way to understand how the costs of parenting have changed over time.
Inflation and purchasing power
Inflation will cause a decrease in real incomes. If the rate of inflation is greater than the growth in nominal income, real incomes decrease.
Change in real US average incomes
The percentage change in nominal income – rate of inflation = change in real income. For example, if average nominal incomes in a country increased by 2.7% in a year where the rate of inflation was 1.9%, then the change in real income would only be + 0.8%.
Inflation reduces the purchasing power of income. This is because the amount of goods and services that can be purchased with a given quantity of nominal income decreases. For example if inflation increased 3% in one year, then every $10,000 of household income at the beginning of the year would purchase more goods and services than it would at the end. At the end of the year it would take $10,300 for the household to purchase the same quantity of goods and services. The amount of goods and services the average household can purchase with a set amount of nominal income decreases and households are worse off – consumer welfare decreases.
Essential statement: The purchasing power of income will remain unchanged if the percentage increase in nominal income is the same as the rate of inflation
The value of money
Inflation and saving
Saving is income not spent. Households typically deposit savings in banks which will then pay them interest on the amount they have deposited.
Banks are borrowing money from savers. Interest is the price paid by banks for the use of borrowed money – it is the money households earn from bank deposits.
The nominal interest rate is the stated or advertised amount of interest that banks pay depositors; i.e., the interest rate before taking inflation into account.
The real interest rate is the rate of interest an investor, saver or lender receives after allowing for inflation.
If banks are paying an average interest rate of 5% and prices are stable (inflation = 0%) then the saver will be able to purchase an extra 5% of goods and services when she withdraws her money in a year’s time. The real interest rate then equals 5%, and the purchasing power of her savings has increased by 5%.
However, if inflation causes average prices in the economy to increase by, say, 3%, then the saver will only be able to purchase an additional 2% (5% - 3% = 2%) of goods and services when she withdraws money at the end of the year. The real rate of interest is 2%, and the purchasing power of her savings has only increased by 2%.
Of course, if inflation runs higher than the advertised (nominal) interest rate (e.g., 2%), then the real interest rate will be negative and the purchasing power of savings will actually decrease.
The lower the real interest rate, the lower the incentive for households to save. And the lower the incentive to save, the more likely it will be that households won’t delay consumption but will bring consumption forward, spending income now rather than later.
Essential statement: The real interest rate = nominal interest rate – inflation rate. Real interest rates take into account the effects of inflation and will determine the real purchasing power of savings
effect of inflation on savings
Real interest rates fall as inflation rates increase. This causes a transfer of resources from savers to borrowers. Inflation reduces the burden of borrowing as it reduces the real value of the borrower’s debt. For example, if a household has a $300,000 mortgage and inflation is 10%, then the real value of that debt has fallen by $30,000.
Further, if a different household had $300,000 in savings, then the real value of their savings would be $30,000 lower at the end of the year than it was at the start. If this household consisted of a pair of pensioners who were counting on using this pot of savings for their retirement, then their purchasing power is being reduced each year that inflation is greater than the nominal interest rate.
The main redistributive effects of inflation can be summarised as follows:
1. Debtors vs creditors:
During periods of rising prices, debtors gain and creditors lose. When prices rise, the value of money falls. Though debtors return the same amount of money, but they pay less in terms of goods and services. This is because the value of money is less than when they borrowed the money. Thus the burden of the debt is reduced and debtors gain.
On the other hand, creditors lose. Although they get back the same amount of money which they lent, they receive less in real terms because the value of money falls. Thus inflation brings about a redistribution of real wealth in favour of debtors at the cost of creditors.
2. Salaried Persons:
Salaried workers such as clerks, teachers, and other white collar persons lose when there is inflation. The reason is that their salaries are slow to adjust when prices are rising.
3. Wage Earners:
Wage earners may gain or lose depending upon the speed with which their wages adjust to rising prices. If their unions are strong, they may get their wages linked to the cost of living index. In this way, they may be able to protect themselves from the bad effects of inflation.
But the problem is that there is often a time lag between the raising of wages by employees and the rise in prices. So workers lose because by the time wages are raised, the cost of living index may have increased further. But where the unions have entered into contractual wages for a fixed period, the workers lose when prices continue to rise during the period of contract. On the whole, the wage earners are in the same position as the white collar persons.
4. Fixed Income Group:
The recipients of transfer payments such as pensions, unemployment insurance, social security, etc. and recipients of interest and rent live on fixed incomes. Pensioners get fixed pensions. Similarly the rentier class consisting of interest and rent receivers get fixed payments.
The same is the case with the holders of fixed interest bearing securities, debentures and deposits. All such persons lose because they receive fixed payments, while the value of money continues to fall with rising prices.
Among these groups, the recipients of transfer payments belong to the lower income group and the rentier class to the upper income group. Inflation redistributes income from these two groups toward the middle income group comprising traders and businessmen.
5. Equity Holders or Investors:
Persons who hold shares or stocks of companies gain during inflation. For when prices are rising, business activities expand which increase profits of companies. As profits increase, dividends on equities also increase at a faster rate than prices. But those who invest in debentures, securities, bonds, etc. which carry a fixed interest rate lose during inflation because they receive a fixed sum while the purchasing power is falling.
6. Business owners:
Business owners of all types, such as producers, traders and real estate holders gain during periods of rising prices. Take producers first. When prices are rising, the value of their inventories (goods in stock) rise in the same proportion. So they profit more when they sell their stored commodities.
The same is the case with traders in the short run. But producers profit more in another way. Their costs do not rise to the extent of the rise in the prices of their goods. This is because prices of raw materials and other inputs and wages do not rise immediately to the level of the price rise.
The holders of real estate’s also profit during inflation because the prices of landed property increase much faster than the general price level.
AN overview of inflation
business certainty, economic growth and employment
The effects of inflation on business certainty, economic growth and employment
There is increased business uncertainty when rates of inflation are high and unstable. Inflation will affect a firms costs of production, pushing up the price of inputs. It is difficult to make long-term business planning and pricing decisions when there is uncertainty about what the costs of production will be into the near future. It is becomes difficult to gauge the real returns on investment projects firms may be considering. All things being equal, the higher the rate of inflation the greater the nominal returns from investment need to be. And the higher the needed returns the more risky investment projects become, which, in turn, lowers the average investment by firms in the economy.
Investment is needed for long-term economic growth because it is only increases in the quality and quantity of factors of production that will shift the long-run aggregate supply to the right and lead to higher levels on income and employment in an economy. Thus, investment projects lead to increased capital stock and increased productivity in an economy, and without investment, full employment levels of output remain unchanged or decrease over time.
Further, investment is a central part of aggregate demand: AD = C + I + G + X – M. Investment is an injection into the circular flow model of expenditure and income. Investment expenditure by firms increase AD by the Keynesian multiplier as investment will create additional employment, raise incomes and generate tax revenues for the government.
Investment will increase long-run aggregate supply. High and unstable rates of inflation decrease the amount of investment that occurs in an economy and the growth in LRAS will be relatively slow.
The levels of investment in an economy will decrease as rates of inflation become high and volatile. Aggregate demand will decrease as a result.
Inflation effects international competitiveness
If a country has a higher rate of inflation than that of its trading partners then this will make its exports less competitive and will make imports from lower-inflation trading partners more attractive. This may lead to lower export revenues and greater expenditure on imports, thus worsening the trade balance. It might lead to unemployment in export industries and in industries that compete with imports.
The decrease in international price competitiveness caused by inflation will reduce aggregate demand and shift the economy to a new, lower level of employment and output: decreaseAD = C + I + G + (decreaseX – increaseM).
Comparatively high inflation will decrease exports and increase imports.
The causes of deflation
Deflation is a sustained decrease in the price level (average prices) in an economy. When deflation occurs the purchasing power of money increases. As average prices in an economy continue to decrease, more and more goods and services can be purchase by household with the same amount of nominal income.
Deflation can be caused by increasing long-run aggregate supply or by decreasing aggregate demand.
Increasing long-run aggregate supply, increases the full employment level of output in an economy, and if aggregate demand remains constant, then the price level will fall (i.e., deflation will occur).
This first type of deflation, "good" deflation, comes about from improvements in the quality and quantity of resources (factors of production) that are available in an economy. Supply-side policies, the introduction of new technology, increases in capital stock and improvements in productivity are the main drivers of increases in long-run aggregate supply.
Supply-side policies: Supply-side policies are mainly micro-economic policies aimed at making markets and industries operate more efficiently and contribute to a faster underlying-rate of growth of real national output (the reduction of rules and regulations governing business activity and improving infrastructure (e.g., roads and internet connectivity).
A simple aggregate demand/aggregate supply diagram illustrates that an increase in the long-run aggregate supply curve can result in an increase in real output and a fall in the price level. If the level of real output increases then we can assume that there is a lower level of unemployment as more workers will be needed to produce the higher level of output.
As aggregate expenditure in an economy decreases: decreaseAD = C + I + G + X – M and firms receive less revenues and earn lower profits, on average. Total Revenue = Price x Quantity of output sold. decreaseTotal revenue = Price x decreaseQuantity as expenditure in an economy decreases. As less goods and services are being purchased, on average, firms will reduce their output, on average. This is shown as a movement down the SRAS curve from AD1 to AD2, above.
Firms that produce less output require fewer inputs into the production process and their demand for the factors of production decrease. Less workers are required and the labour force decreases – unemployment increases.
Decades of Japanese deflation
No, falling prices aren't good!
1. From the initial equilibrium where AD1 = SRAS1 = LRAS, AD1 decreases – shifting downwards to the left – to AD2.
2. The price level falls from PL1 to PL2. As average prices in the economy fall, so too does the value of expenditure on goods and services. Firms are faced with reduced profitability and as a result, reduce the supply of goods and services they produce. This is shown as a downward movement along the SRAS1 curve from 1 to 2.
Derived demand for the factors of production. The demand for resources (factors of production) are derived from the demand for goods and services; i.e., if demand for the good or service produced by a firm increases, then that firm will demand additional labour, land, capital, etc. If there is a decrease in demand for a firm’s goods or services, then output will be reduced and the firm will demand fewer resources to be used in its production processes. If this happens at the aggregate level, then the demand for labour will fall in the economy and there will be an excess supply of labour (i.e., unemployment). The forces of supply and demand in the labour market will work to eliminate the excess supply (surplus) of labour in the economy, decreasing the price of labour (wages) to firms.
Thus, as aggregate demand decreases the demand for the factors of production decreases, and the price paid by firms for the factors of production will decrease, on average.
The new classical/monetarist model does not allow for any form of government intervention. If the factor markets are free markets then the prices of resources, including the wage rate for labour, will change instantly as the demand for the factors of production change. Thus, there will be an immediate change in the costs of production of firms. This brings us to the third step in the sequence of events that occur following a change in one of the determinants of aggregate demand:
3. At point 2 in the figure above, where average prices in the economy are at P2 and national output is at Y1, the economy is producing below the level of full employment level of output (real GDP). This level of output is short-lived as the prices of the factors of production fall, reducing firms’ costs of production, on average. With increased profitability, firms increase output to YF once again and this is shown as a downward movement along the AD2 curve from 2 to 3. As the supply of firms increases, on average, then short-run aggregate supply increases from SRAS1 to SRAS2. Thus, the economy will automatically return to its long-run equilibrium of full employment level of output at YF following any change in a determinant of aggregate demand.
4. Finally, as firms increase their output, they must reduce their prices to sell additional units of output and increase the quantity demanded by those in the market for their goods and services. Further, as prices for resources decrease, firms in competitive markets will pass these cost savings on. On average, prices fall and the price level decreases further from P2 to P3.
consequences of deflation
Costs of deflation
Although, as consumers, we might be pleased to face falling prices, a significant number of problems can be associated with a fall in the price level. In fact, economists might argue that the costs of deflation are greater than the costs of inflation.
Unemployment. The biggest problem associated with deflation is unemployment. If aggregate demand is low then businesses are likely to lay off workers. This may then lead to a deflationary spiral. If prices are falling, consumers will put off the purchase of any durable goods as they will want to wait until the prices drop even further. This may be referred to as deferred consumption.
This will further reduce aggregate demand. If households become pessimistic about the economic future then consumer confidence will fall. Low consumer confidence is likely to further depress aggregate demand. Thus, a deflationary spiral may occur.
Effect on investment. When there is deflation, businesses make less profit, or make losses. This may lead them to lay off workers.
Furthermore, business confidence is likely to be low and this is likely to result in reduced investment. This has negative implications for future economic growth.
Costs to debtors: Anyone who has taken a loan (this includes all homeowners who have taken a mortgage to buy their home) suffers as a result of deflation because the value of their debt rises as a result of deflation. If profits are low, this may make it too difficult for businesses to pay back their loans and there may be many bankruptcies. This will further worsen business confidence.
A better argument as to why do economists so dread falling prices is linked to real interest rates. One common explanation is that in anticipation of falling prices, consumers delay purchases, causing them to fall still further. This argument is a simplification; it can be made with equal power in reverse to argue that inflation will inevitably run upwards as consumers bring purchases forward to avoid higher prices later. But the argument hints at the right problem: deflation’s effect on interest rates. Generally speaking, the interest rate reflects the price of consumption today relative to consumption tomorrow. When interest rates are high, savings are worth more tomorrow, and vice-versa. The return in money terms (the rate advertised by banks) is called the “nominal” interest rate. But inflation also matters. Subtracting expected inflation from the nominal rate produces the real interest rate – the expected return after inflation – which is what people respond to in most models of the economy.
Low inflation or deflation constrains this crucial variable. The nominal interest rate cannot fall below zero, because that would mean reducing savers’ bank balances every month, and would prompt them to withdraw their deposits from banks and stash cash under the bed. Together with inflation, this puts a floor on the real interest rate too. If inflation is low and real rates can’t fall far enough to boost demand and perk up prices, demand will weaken still further. This is the dreaded deflation trap. There are other problems, too. Lower-than-expected inflation increases the real burden of debts. Lenders benefit, but because they are more likely to save than borrowers, demand is sapped overall. Deflation also increases rigidity in the labour market. Workers are resistant to wage cuts in cash terms, but inflation lets firms cut real wages by freezing pay in nominal terms. Deflation, by contrast, makes this problem worse.
To avoid the trap, central banks can resort to unconventional policies such as quantitative easing, although there is debate over their fairness and efficacy. In the long run, some economists think inflation targets should be higher. That would give more room for real interest rates to fall when economies are hit by negative shocks. But in a few decades, the problem may disappear: in a cashless economy it is impossible to stash money under the bed. That would allow nominal interest rates to go negative, as everyone’s bank balance could simply be reduced simultaneously. But that might be easier said than done.
Demand Pull Inflation
Demand-pull inflation is used by Keynesians to describe what happens when price levels rise because of an imbalance in the aggregate supply and demand. When the aggregate demand: AD = C + I + G + X - M in an economy strongly outweighs the aggregate supply, the price level (average prices) increases.
For example, an increase in consumer confidence would lead to an increase in aggregate demand as the spending of consumers increased: increaseAD = increaseC + I + G + X – M. Additionally, firms are likely to respond to the increase in consumer expenditure and increase their levels of investment to increase output levels. Aggregate demand further increases: increaseincreaseAD = increaseC + increaseI + G + X – M. Increasing aggregate demand “pulls up” prices in the economy, as can be seen below.
Total aggregate demand for goods and services exceeds the economy’s ability to supply them (total output). Firms can increase the amount of goods and services in response to increases in expenditure, but if the rise in expenditure is rapid, and exceeds the capacity of the economy (remembering that factors of production become scarce at high levels of output), then the price level will increase before long-run aggregate supply chance has a chance to increase.
Essential statement: When aggregate demand increases at a faster rate than aggregate supply, the price level increases to eliminate excess aggregate demand
Demand pull inflation explained
DEmand pull vs Cost push
Of course, at low levels of aggregate demand which occur when an economy is in recession, then increases in AD will not lead to significant increases in inflation (a sustained increase in the price level), as shown below. Increases in AD must increase economic output (real GDP) towards the full employment level of output (YF) before demand-pull inflation becomes manifest
cost push inflation
Cost-push inflation: A sustained increase in the price level (average prices) which results from decreased aggregate supply which, in turn, is the result of increased costs of production (e.g., increased prices of factor inputs) and/or supply-side shocks.
Essential statement: Cost-push inflation is a result of increasing costs of production, on average, which causes firms to increase prices to maintain profit margins
Profit margin: The amount by which revenue from sales revenues exceed costs in a business.
For example, if a firm has sales of $20 million and costs of production of $18 million, then it has a profit margin of 10%: [($20m - $18m) ÷ $20m x 100] = 10%.
If costs of production rise (increased wage rates, rents, interest payments, etc.) then profit margins shrink. Thus, if the costs of production above increased by 10% then the firm’s costs would increase by $1.8 million (10% of $18m) to $19.8 million, and the profit margin would decrease: [($20m - $19.8m) ÷ $20m x 100] = 1%.
It is very likely that the firm would increase prices to boost sales revenues and increase its profit margins. And, it is even more likely to do when firms, on average, in the economy are experiencing the same increases in costs of production; i.e., it’s difficult to raise prices if you are the only firm in town to do so, but easier when most firms are facing the same competitive pressures to do so.
As can be seen above a decrease in aggregate supply from SRAS1 to SRAS2 causes an increase in the price level from PL1 to PL2, and it also results in falling output and income (real GDP) from Y1 to Y2. This increases unemployment in the economy as the PL increases and AD decreases along the AD curve between SRAS1 and SRAS2.
Essential statement: Cost-push inflation is a result of increasing costs of production, on average, which causes firms to increase prices to maintain profit margins
What is cost push inflation?
Demand pull vs cost push
Cost-push inflation can also result from supply-side shocks.
A supply-side shock is an event that suddenly increases or decreases the supply of goods and services in general. This sudden change affects the equilibrium price of the goods or services an economy is producing, on average, and thus the economy's general price level. Supply-side shocks include natural disasters such as earthquakes, tsunamis, floods and droughts. Sometimes a currency will collapse and imports used in the production process become prohibitively expensive. Other times, inflation will be rampant pushing up the cost of the factors of production (e.g., the inflation rate in Venezuela in 2016 was conservatively estimated at around 800 percent; although it should be noted that inflation itself was not the supply-side shock, but rather the poor governance of the country and the printing of money by the central bank).
Other supply-side shocks have included the OPEC oil embargo of the 1970s which reduced oil supplies and pushed up the price of oil dramatically. An example of a positive supply-side shock would be large leaps in the development of technology, such as the Internet back in the 1990s, and perhaps the development of artificial intelligence as we head into the 2020s.
the Different types of inflation
GOvernment policies for a low and stable rate of inflation
Fiscal policy and monetary policy can be used by governments and their institutions to control inflation.
Monetary policy: The process by which the monetary authority of a country, like the central bank, controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability.
Central bank: A national bank that provides financial and banking services for its country's government and commercial banking system, as well as implementing the government's monetary policy and issuing currency.
Independent central banks set interest rates in developed economies with the objective of maintaining price stability. If the central bank believes that inflationary pressures look likely to increase in the short-to-medium term, it will increase interest rates in the economy.
Higher interest rates have various economic effects:
Therefore, higher interest rates will tend to reduce consumer spending and investment. This will lead to a fall in aggregate demand: decreaseAD = decreaseC + decreaseI + G + decrease(X – M).
Lower AD causes:
Contractionary monetary policy: The central bank increases the base interest rate in an economy causing borrowing for consumption and investment to become relatively more expensive and the exchange rate to appreciate.
Expansionary monetary policy: The central bank decreases the base interest rate in an economy causing borrowing for consumption and investment to become relatively less expensive and the exchange rate to depreciate.
Essential statement: Higher interest rates increase the costs of borrowing and decreases consumer and investment expenditure being financed by loans
Essential statement: Higher interest rates increase the costs of borrowing and decreases consumer and investment expenditure being financed by loans
Monetary policy explained
Fiscal policy explained
Fiscal policy: The use of government revenue collection (mainly taxes) and expenditure (spending) to influence the level of economic activity.
Reduced government spending and/or increased taxes decreases aggregate demand.
Governments can run a budget surplus when inflation pressures look likely to build. A budget surplus is when government revenues are greater than government expenditure. A budget surplus acts as a withdrawal from the circular flow if income and expenditure because the government is in effect saving the surplus, i.e., deferring expenditure today for some future point in time (perhaps when the economy slips into recession and a boost to aggregate demand is required to stabilise national output and income).
Government spending is a core component of aggregate demand and decreases in government spending will decrease the rate of inflation: decreaseAD = C + I + decreaseG + X – M.
An increase in personal income tax will cause disposable incomes to decrease, and as consumers have less disposable income, household expenditure on goods and services will decrease and reduce the level of aggregate demand in an economy: decreaseAD = decreaseC + I + G + X – M.
In either case, reduced government expenditure or increased taxation decrease aggregate demand and shift the AD curve left, decreasing the price level as shown below.
Essential statement: An increase in tax rates decreases the disposable income of households and the profits of firms, and with reduced consumer expenditure and lower investment from firms AD decreases
Supply-side policies to reduce inflation.
Supply side policies are government policies which seek to increase the productivity and efficiency of the economy.
Supply side policies aim to increase long term competitiveness and productivity. For example, it was hoped that privatisation and deregulation would make firms more productive and competitive. Therefore, in the long run supply side policies can help reduce inflationary pressures. However, supply side policies work very much in the long term; they cannot be used to reduce sudden increases in the inflation rate. Also, there is no guarantee government supply side policies will be successful in reducing inflation.
Supply-side policies can involve interventionist supply side policies (e.g. government spending on education) or free market supply side policies (e.g. reduce government legislation).
The main macro-economic objectives of the government include:
To achieve all objectives simultaneously it is essential to improve the supply side of the economy. If the government can increase productivity and shift AS to the right, it can enable low inflationary growth.
To attain rates of low and stable inflation, supply side policies can help reduce costs and increase productivity. For example, privatisation and deregulation can help reduce costs. However, in the control of inflation, the most significant factor is the use of monetary policy and controlling AD through interest rates. Supply side policies will take a long time to have any effect on reducing inflationary pressures.
Supply side policies can be very beneficial. However, in practise it is not always so easy to increase productivity. Also, there is a limit to how much benefit they can give, it is often more appropriate to use demand side policies.
evaluating GOVERNMENT inflation policies
Advantages of monetary policy in setting interest rates:
Limitations of the monetary policy’s effectiveness:
In sum, monetary policy has done a good job so far in developed countries. However the real test may come when there is a rise in structural inflation or global instability.
All developed economies use monetary policy, as their first-choice policy to achieve a low and stable rate of inflation.
In theory the government can reduce spending and/or increase taxes to reduce aggregate demand. As aggregate demand decreases there is less demand from firms for the factors of production, especially labour. This lowering of prices firms pay for their factors of production lowers inflation pressures associated with short-run aggregate supply – cost push inflation.
However, any fall in aggregate demand is going to be associated with increased demand-deficient unemployment. There is a trade-off faced here between inflation and unemployment.
Further, as aggregate demand decreases, tax revenues decrease and government expenditure on transfer payments (e.g., unemployment benefits) and education and training programmes increase. Lower tax revenues and higher government spending will decrease a budget surplus, crease a budget deficit or widen an existing budget deficit, depending on how the government’s books were balanced prior to a contractionary fiscal policy being implemented. Budget deficits add to the national debt.
Other issues associated with a contractionary fiscal policy:
Supply-side policies and cost-push inflation.
To attain low inflation, supply side policies can help reduce costs and increase productivity. For example, privatisation and deregulation can help reduce costs. However, in the control of inflation, the most significant factor is the use of monetary policy and controlling AD through interest rates. Supply side policies will take a long time to have any effect on reducing inflationary pressures.
Unemployment and inflation in the short-run
The possible short-run trade-off between the unemployment rate and the inflation rate
There is a possible trade-off, in the short-run, between inflation and unemployment assuming that there is a negative causal relationship between the monetary wages firms pay their employees and the level of unemployment.
An increase in aggregate demand requires firms to increase output, and to increase output firms will employ more labour. When levels of aggregate demand are relatively low, such as in an economic recession, the labour supply is plentiful given the large numbers of unemployed in the labour force. At this point in the business cycle, the beginning of an expansion, demand for labour is still relatively low and the supply of labour is relatively high. Low demand for labour and a large supply of labour means that there is no increase in money wages in the economy.
As the economy continues through the business cycle and begins to attain its full employment level of output at the peak of the business cycle, the supply of labour is scarce – unemployment in the economy is at its lowest levels. The scarcity of labour means that firms continuing to expand output must compete with each other to attract both unemployed workers from the shrinking pool of unemployed as well as workers away from other firms. Firms offer higher wages to do so and the price of wages increase.
Thus, as unemployment decreases in the expansions and peaks of the business cycle, the price of wages increases.
As economic activity decreases in the contraction and trough phases of the business cycle, and the economy moves further away from the full employment level of output, we see the reverse trend emerging. At low levels of economic activity, employment is low and unemployment high as firms reduce output and make workers redundant. When unemployment is high, it is possible that willing workers may accept lower wages to gain employment, and it may be possible that workers currently employed may accept lower wages in order to retain their jobs.
Thus, as unemployment increases in the contractions and troughs of the business cycle, the price of wages decreases.
Wages are the main cost of production to firms. Costs of production are reflected in the rate of inflation. In order to maintain profit margins, firms typically pass on their increased costs of production in the form of higher prices.
When wage rates decrease, firms have lower costs of production and competitive pressures can see these cost savings passed on as lower prices to the buyers of goods and services. When the costs of production decrease, firms can lower the prices of their goods and still maintain profit margins.
Decreases in the costs of production lead to lower levels of inflation in the economy, and higher costs of production result in higher rates of inflation (cost-push inflation).
Increased economic activity results as the economy moves closer its full employment level of output, and as unemployment decreases (e.g., 2% to 5%), inflation increases (e.g., 3% to 6%), as can be seen below.
the Phillips curve
The phillips curve explained
the Phillips Curve
The Phillips curve represents the relationship between the rate of inflation and the unemployment rate.
Essential statement: An increase in aggregate demand results in increased demand for labour as firms increase output, and unemployment decreases. Increases in aggregate demand cause cost-push and demand-pull inflation. Thus, a trade-off between unemployment and inflation can exist
The Philip curve supposes that there is a negative relationship between unemployment and inflation. An economy cannot have low inflation and low unemployment at the same time.
Contractionary fiscal and monetary policies can decrease the rate of inflation in an economy, but the result will be higher levels of unemployment. Conversely, expansionary fiscal and/or monetary policy can work to decrease levels of unemployment, but the trade-off is higher inflation. Thus, examining the diagram above, any of the points A-D are possible, but not E which is a point of both low inflation and low unemployment.
The curve suggested that changes in the level of unemployment have a direct and predictable effect on the level of price inflation. The accepted explanation during the 1960’s was that a fiscal stimulus, and increase in AD, would trigger the following sequence of responses:
The shape of the Phillips curve is determined by the short-run AD/AS model, where the rate of inflation in the Philips curve corresponds to the equilibrium price level, and the unemployment rate is determined by the equilibrium level of output. High output (real GDP) corresponds to a low unemployment rate, and vice versa for low levels of output.
Thus, at point A above where AD1 is relatively low, so too is the rate of inflation and unemployment is relatively high because output is low (Y1). The opposite pattern occurs at AD4/AS equilibrium associated with point D. At point D, output is relatively high, and therefore unemployment is relatively low, the price level is relatively high and the economy would be experiencing a high rate of inflation. Points A-D in the AD/AS model correspond to points A-D on the Phillips curve.
Stagflation occurs when persistent high inflation is combined with high unemployment and stagnant demand in a country's economy. The trade-off between unemployment and inflation breaks down, because countries can have high rates of demand deficient unemployment and high rates of inflation.
Stagflation results from supply-side shocks which cause costs of production to increase, on average, through an economy and decreases short-run aggregate supply.
The short-run Philips curve can shift right, causing stagflation
A supply-side shock is an event that suddenly increases or decreases the supply of goods and services in general. This sudden change affects the equilibrium price of the goods or services an economy is producing, on average, and thus the economy's general price level.
Supply-side shocks include natural disasters such as earthquakes, tsunamis, floods and droughts. Sometimes a currency will collapse and imports used in the production process become prohibitively expensive. Other times, inflation will be rampant pushing up the cost of the factors of production (e.g., the inflation rate in Venezuela in 2016 was conservatively estimated at around 800 percent; although it should be noted that inflation itself was not the supply-side shock, but rather the poor governance of the country and the printing of money by the central bank). Other supply-side shocks have included the OPEC oil embargo of the 1970s which reduced oil supplies and pushed up the price of oil dramatically.
Short-run aggregate supply shifts left from SRAS1 to SRAS2 as costs of production increase, on average, causing the price level to increase from PL1 to PL2 – inflation – and output and incomes decrease from Y1 to Y2. Firms lay make workers redundant as output decreases and unemployment increases. The economy has increasing unemployment and inflation. An increase in each price level there is increased unemployment.
The Phillips curve shifts right, illustrating the new relationship between inflation and unemployment. The economy is operating at YF and point 1 before the supply-side shock. Both the rates of inflation and unemployment are higher after the supply-side shock at point 2.
Essential statement: Cost-push inflation results from a supply-side shock which increases firms’ costs of production, on average. There is a decrease in short-run aggregate supply which increases the price level and results in decreased national expenditure. In response, firms make workers redundant as they decrease supply and unemployment increases.
Stagflation in the 1970s
UNEMPLOYMENT AND INFLATION IN THE LOng-RUN
There is no trade-off between inflation and unemployment in the long-run.
The monetarist theory of AD/AS states that in the long-run the economy will automatically return to the full employment level of output.
Decreases in aggregate demand will cause wage rates to fall (as surplus labour exists) and SRAS will then increase as costs of production fall. Likewise, increases in aggregate demand cause wage rates to rise (as labour becomes scarce) and SRAS shifts left as costs of production increase.
Monetarists thus conclude that there is no long-term trade-off between inflation and unemployment.
Consider the diagram below. If, for example, aggregate demand increases because the exchange rate depreciates making exports relatively more profitable and imports relatively more expensive: decreaseAD = C + I + G + (decreaseX – increaseM), then the following sequence of events occur:
the Short-run phillips curve
The long-run phillips curve
In the figure above, at point 1 the inflation rate is 3% and unemployment is at 5%. Economic activity is at the full employment level of output, and therefore, there is zero demand-deficient unemployment in the economy. At this point, the only unemployment in the economy is frictional and structural (frictional unemployment + structural unemployment = natural unemployment). At point 1 the natural rate of unemployment is 5%.
Now, for example, if the government attempted to lower unemployment below the natural rate of unemployment by running an expansionary fiscal policy then aggregate demand would increase and so too would the rate of inflation. The increase in aggregate demand: increaseAD = increaseC + increaseI + increaseG + X – M results in both demand-pull and cost-push inflation in the economy. Simultaneously, the demand for labour increases as firms look to increase their output to meet the increased demand in the economy for their goods and services. To increase output firms needs to hire additional labour. As firms compete with each other to secure increasingly scarce labour, they bid up the price of labour and wages increase.
As the average wage rate increases, voluntary unemployment decreases as higher wages attract those who were unwilling to supply their labour at lower wages into the labour market. Short-run unemployment decreases from 5% to 2%. The higher rate of inflation and the decrease in unemployment is shown as a movement up the short-run Phillips curve – SRPC1 – from points 1 to 2.
Initially, the new entrants attracted by higher wages into the labour market are under the money illusion. As soon as they realise that the purchasing power of their wages has been reduced by the increase in inflation, they withdraw their labour from the market.
The initial increase in inflation causes inflation expectations to rise; i.e. workers now expect the rate of inflation in the future to be higher than it was before (6% not 2%). As workers negotiate wage rates with firms they are likely to demand and receive higher wages based on their inflation expectations and the fact that labour is scarce in the economy at this point in time (at 2).
Increased wage rates increase the costs of labour to firms and the demand for labour decreases. Firms lay off workers and unemployment increases. The economy returns to the full employment level of output, moving from 2 to 3. The rate of unemployment returns to 5% but inflation remains high at 6%). The expansionary fiscal policy aimed at reducing the rate of unemployment has failed.
If the government continues with efforts to increase aggregate demand to reduce the rate of unemployment by increasing fiscal stimulus (running an even more expansionary fiscal policy), then the process repeats itself. Unemployment decreases and inflation increases as the economy moves from points 3Ž to 4 along SRPC2. And increased wage rates reduce the demand for labour and unemployment increases with an even higher level of inflation (points 4 to 5).
The point to this is that there is always going to be a natural rate of unemployment in an economy, even when economic activity is occurring at the full employment level of output. There will be people who are:
In the long-run there is no trade-off between employment and inflation.
The non-accelerating inflation rate of unemployment (NAIRU) - also referred to as the long-run Phillips curve – is the specific level of unemployment that is evident in an economy that does not cause inflation to rise up. NAIRU often represents equilibrium between the state of the economy and the labour market.
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