2.4: Inflation



  1. Inflation is a persistent increase in the average price levels in the economy, usually measured through the calculation of consumer price index (CPI). Inflation results in a fall in the value of money.
  2. Demand-pull inflation is a persistent increase in the average price levels in the economy (inflation) that is caused by increasing aggregate demand, that is, a shift of AD curve to the right.
  3. Cost-push inflation is a persistent increase in the average price levels in tbe economy that is caused by an increase in the costs of factors of production, that is, a shift of SRAS curve to the left.
  4. Deflation is the persistent fall in the average price levels in the economy, usually caused by falling aggregate demand or an increase in aggregate supply.
  5. Disinflation is a fall in the rate of inflation, i.e. the average price levels are rising, but at a lower rate than in the previous year.
  6. Stagflation is when real output, hence employment, fall, even though there is inflation (a persistent increase in the average price levels) in an economy. Stagflation is caused by a shift of the aggregate supply curve to the left.
  7. Core rate of inflation is an adjusted measure of inflation (a persistent increase in the average price levels in the economy) that removes distortions of the most volatile prices of items such as food and energy.
  8. Short-run Phillips curve shows the inverse relationship between the rate of unemployment and the rate of inflation, which suggests a trade off between unemployment and inflation.
  9. Long-run Phillips curve shows the monetarist (new classical) view that there is no trade off between unemployment and inflation and that there exists a natural rate of unemployment that can only be affected by supply-side policies.
  10. Natural rate of unemployment is consistent with the stable rate of inflation and where the long-run Phillips curve touches the x-axis.








Costs of inflation


1. Loss of purchasing power

  • When inflation rate increases, the price of the product also increases at the same rate.
  • If income is constant, people aren’t able to buy as many products as they used to.
  • Therefore, people have loss of purchasing power.
  • However if inflation is linked to income, then the income rises at the same rate as inflation rate. So they won’t have a fall in real income.
  • Many people have jobs that don’t offer the security of inflation-linked incomes because of they have fixed incomes, self-employed or they have weak purchasing power.
  • Thus inflation reduces their purchasing power and standards of living.


2. Effect on saving

  • If the inflation rate increases over a year, then the interest rate will be negative.
  • So savings will not be able buy as much as they could have in the previous year.
  • It would better to spend money than save it so they can avoid loss of purchasing power.
  • If people tend to save money, they would spend it on fixed assets rather than buy products → Reduces investment and have negative consequences for economic growth.


3. Effect on interest rates

  • If inflation rate increases, then banks raise their nominal interest rates to keep up with the real rate so that they earn positive interest.


4. Effect on international competitiveness

  • If a country has higher inflation rate than their trading partners, then their exports become less competitive.
  • Imports from lower inflation trading partners will be more attractive.
  • This will lead to fewer export revenue and greater import expenditure, which worsens trade balance in an economy.
  • Unemployment will occur in export industries.


5. Uncertainty

  • Firms will be discouraged to investing due to uncertainty in inflation rates → Negative consequences of economic growth.


6. Labor unrest

  • Occur when workers don’t feel their wages and salaries are keeping up with inflation → Conflict between unions and management.

Costs of deflation


1. Unemployment

  • Low aggregate demand → Firms lay off more workers → Deflationary spiral.
  • If prices are falling, consumers will wait to purchase products until the price falls even further → Reduce aggregate demand.
  • If households are pessimistic about economic future → Consumer confidence decreases → Reduces aggregate demand → Deflationary spiral.


2. Effect on investment

  • Businesses make less profit or losses when there is deflation.
  • Firms have to lay off workers.
  • Business confidence will be low → Reduced investment → Negative consequence for future economic growth.


3. Costs to debtors

  • Anyone who took a loan suffers as a result of deflation because the value of their debt rises as a consequence.
  • If profits are low, then this might make it too difficult for businesses to payback their loans → Increase in bankruptcies → Worsen business confidence.


Difficulties in measuring inflation.


  • The basket used to represent purchasing habits of a typical household might not be applicable to all people in a country.
  • Errors in data collection might limit accuracy in final results as countries don’t collect prices of all items bought by all people in all of their countries. It is very time consuming and costly.
  • Items in the basket are removed and added to be more representative of a typical household, but it is time consuming and it will limit the comparison between two years of a country as not the same products in the basket are used in two years that are compared.
  • Countries measure inflation rates differently and uses different components → Problematic when inflation rates are compared with foreign countries.
  • Prices may change for reasons that aren’t sustained, such as seasonal variations. Economists use core inflation rate to remove those items for more reliable data.
  • CPI only measures change in consumer price index, when more stakeholders are affected by the economy. So economists may use commodity price index or producer price index to increase credibility for data in calculating inflation rate.

Causes of inflation


1. Demand-pull inflation

  • Occurs as aggregate demand increases in an economy.

●       Causes of demand-pull inflation:

  • Changes in components of aggregate demand.

●       Ways to reduce demand-pull inflation:

  • Impose contractionary demand side policies, i.e. decrease money supply and government spending, increase tax and interest rates.
  • Monetary policies are way more effective than fiscal policies.

●       Problems in methods to reduce demand-pull inflation:

  • Citizens might not be happy with paying higher taxes and interest rates.
  • Reduction in government spending will impact many people as their income depends on the government → Less support for the government.
  • Long time lag involved in imposing contractionary demand side policies.
  • Higher interest rates means higher loan and mortgages payments → Unpopular!

2. Cost-push inflation

  • Occurs as production costs increases.

●       Causes of cost-push inflation:

  • Increase in price levels due to increase in labor costs.
  • Changes in costs of domestic materials.
  • Changes in costs of imported capital and components.
  • Fall in value of a country’s currency.

●       Ways to reduce cost-push inflation:

  • Using contractionary demand side policies.
  • However, since that is effective, supply side policies would be more appropriate.

●       Problems in methods to reduce cost-push inflation

  • Lower national income.
  • Increase in unemployment.

3. Inflation due to excess monetary growth

  • Increase in money supply → Increases spending → Increases aggregate demand.
  • However, the output remains at full employment level of output as price continues to increase, which can be problematic.

Phillips curve

  • Low level of unemployment → Higher wages for workers.
  • High level of unemployment → Lower wages for workers due to high competition for jobs.
  • Wages could fall at high levels of unemployment as workers would rather work at lower wages than be unemployed.
  • There’s an inverse relationship between inflation and unemployment rate, therefore there’s a trade off between both of them.
  • In the long run, there is no trade off between inflation and unemployment.
  • Natural rate of unemployment occurs in the long run as the unemployment rate is consistent with inflation rate.
  • Supply side policies will reduce the natural rate of unemployment.

Paper 3 question


Basket of goods and services consumed by an average household in the course of a year includes three times (X, Y, Z) as shown below.