AS Economics (Macro)

Chapter 6: Inflation

Money: it is anything that is generally accepted as a means of payment.

nicholes debit cards credit cards)
Money includes notes coins & bank deposits (
,
,

Characteristics of money
of some
1. Scarcity: should be limited in supply to be1-value Bee
bale
2. Acceptability: it is a generally accepted legal tender which isn’t refused by anyone
3. Divisibility: can be divided into smaller units
4. Durability: it is long lasting and not perishable
5. Portability: easy to carry
(all these characteristics make money better than barter)

Barter system: exchange of goods with other goods

Problems with Barter

1. Double coincidence of wants

2. Determination of ER’s
3. Problems of savings

Functions of Money

1. Median
• Aof exchange: acts as an instrument in transaction of goods and services as it

is generally acceptable and it facilitates trade

2. Unit of account: money expresses the value of each good through its price or an
exchange rate and it facilitates accounting
3. Standard of deferred payment: it facilitates credit payments and simplifies lending
and borrowing
4. Store of value: money can be easily saved and accumulated, while money retains its
value except in the case of high inflation

Inflation: it is the sustained increase in the general price level in an economy over a given
time period -@=7% ,
Does that mean Ps of all

ang figure of
Tin CPI
goods Tby7% ? No ! artisan
.

is

Teams/Types of inflation No This

is
ii) Does this
good becoming enpensiue ?
is
each
mean
.

Tin CPI but some goods

avg figure of may
become
cheaper
.
an

1. Creeping inflation: low levels of inflation (1-5%) ideal 𝜋= 2-3%

2. Running inflation: double digit inflation
3. Hyperinflation: ( 𝜋 ≥ 100% ) when money loses its value so much that it loses its
Pit by 10%
.

pin by 137
function of medianaloofly
⑨ and exchange
! d- =/0%
.

13% ; 2020
'
-

a-
4. Disinflation: when inflation rate but Price level 2019
: - =

5. Deflation: when rate of inflation is -ve and Price level 2016 : a- = -3% -

SIR SOHAIB ALAVI [email protected] Typed by Ahmed Mansoor

A level LGS Gulberg (2020-22)
 YEARS 2010 2011 2012 2013 2014

INFLATION 10% 15% 7% 3% −1%

IMPACT Price Price Price level Price level Price

ON Ps level level 7% 3% level
10% 15% 1%
Disinflation
TERM Running Running Disinflation (creeping) Deflation
𝜋 𝜋

% change in price (inflation)

8
%
7 7

jgcp.i@ta tlRia nseaieynHRtathd tzg.q

6 ,
is NOT 125 < a
5 constant ) 5 @
v1 It
4 ñ=3% '

Bey
bag
•

, ,j
rate
3 3 3
2 ¥3 1¥ 13€ )
(4^21--4-6)
1 A- f-
(Rcoustaut)
0 100g0 0 0 -

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 130

Year 6 veñ(Put
Year 7
-1 )
-2
127
Deflation
-2
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
-3

?= 5/6
In which yeaawaspuhighest
"
" R lowest ? 1 =

" "

SIR SOHAIB ALAVI [email protected] Typed by Ahmed Mansoor

A level LGS Gulberg (2020-22)
 The above diagram shows the inflation data of a country for 7 different years.
➢ Year 0-1 (grey line): Inflation = 3%. Inflation constantly increased till the end of the
1st year, and hence prices rose at an increasing rate in the 1st year at 3%.
➢ Year 1-2 (orange line): inflation = 3%. Meaning prices increased at a constant rate
of 3%.
• a common mistake made by students is that they think that prices
Key point 7:
remained constant in the 2nd year. That is NOT true. Prices increased, but at a
constant rate of 3%.
➢ Year 2-4 (red line): Inflation rose from 3% to 7%. Meaning prices increased at an
increasing rate during these two years (same as point 1),
➢ Year 4-5 (yellow line): Disinflation. Inflation fell consistently from 7% to 0%.
Meaning prices increased this year at a decreasing rate, till they became constant
at the end of the year.
Key point •8: another common mistake students make is that they think prices are
decreasing during the 5th year. That is NOT true. Prices are increasing, but at a
decreasing rate.
➢ Year 5-6 (black line): Inflation = 0%. This means prices are constant, as there is no
inflation is the economy.
➢ Year 6-7 (green line): Deflation of 2%. Meaning prices are decreasing at 2% by the
end of the year.
Key point 9:
• Keep in mind: highest price level in this time period was in year 5 as in
st
the 1 , while minimum price level in this time period was in year 1 (excluding yr 0)

SIR SOHAIB ALAVI [email protected] Typed by Ahmed Mansoor

A level LGS Gulberg (2020-22)
 CPI (consumer price index): CPI is the cost of living index of an economy/determine general price level

fiuflationmeaustherftinCPI.Ayeartgmompa.se
Note : - Rate
Method to calculate CPI

Steps as follows
allottee A- fear
is
.

heung
whoseuflafwig '

1. Select base year and current year

- -

2. Selection of basket of goods that an average household purchases

3. Collection of price data of each category of goods chosen of in step 2 ( both BYICY)
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒
4. Calculate the relative price index = ( 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 × 100 ) of each good
5. Assigning weights to each category of good bases on proportion of expenditure of
𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝑔𝑜𝑜𝑑𝑠
each category ( WEIGHT= × 100 )
𝑡𝑜𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 ④ ✗ ⑤
6. Calculate weight index of each category of good =( 𝑖𝑛𝑑𝑒𝑥 × 𝑤𝑒𝑖𝑔ℎ𝑡 ) and add all
values to total weight index
𝑡𝑜𝑡𝑎𝑙 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑖𝑛𝑑𝑒𝑥
7. Calculate CPI= 𝑡𝑜𝑡𝑎𝑙 𝑤𝑒𝑖𝑔ℎ𝑡
( )
year egzozo
𝐶𝑃𝐼𝑡 −𝐶𝑃𝐼𝑡−1 current
t
(f)
:
× 100
-

8. Inflation=
previous yeaelegzo 'D
𝐶𝑃𝐼𝑡−1
t -1 : -

Problems in calculating CPI may be selection of base year; sampling errors, avg prices
and weights etc. all difficult CPI of base year = 100

step ② ¥0s Step ④ steps steps

PRICE PRICE PRICE WEIGHT
GOODS EXPENDITURE WEIGHT
BASE CURRENT INDEX INDEX

X 5 8 5000 160 50 8000

Y 10 12 2000 120 20 2400

Z 10 8 3000 80 30 2400

E. 12
'

É > Soo

Base Year 100

NoTE__ CPISF
__
: -

SIR SOHAIB ALAVI [email protected] Typed by Ahmed Mansoor

A level LGS Gulberg (2020-22)
Causes of inflation

1. Demand pull inflation (DPI): when there is too much demand in economy relative to
supply of goods AS
Pip - -
- - - - -

uuwuwuw
1.As Aggregate demand from AD1 to AD2
= . - -
- - I
there is no DPI as economy has excess capacity i.
ADO
2.DPI during intermediate capacity as AD from
g-
-
- - - - - -

, ;
ADS
AD3 to AD4 but economy grows too - -

→ - - . . -
, , i
1 I

3.Only DPI during full employment as AD

AD5 to AD6
from
:* : : :
I
1 1 !
ADN
ADA AD, 1 , IAD ,
/ →
→
yp Y
DPI occurs when either C, I, G, (X–M) increases, it can be good if it is creeping during
intermediate capacity, with in profits + income + output.
One of the biggest causes of demand pull inflation is MONETARY INFLATION which is caused
by an increase in money supply in the economy.

2. Cost push inflation (CPI): when cost of production is high in the economy which
aggregate
lowers supply of economy
.
Asz AS ,
PL
1.As cost of production aggregate supply and
economy suffers from stagflation (supply price ) Pz - - - - - - - - -
,

2. it is always bad as it leads to in profit, income, pit - . . .

. - -
I
I
- +

1
employment, and GDP, hence causing
STAGFLATION in the economy.
"
I AD .

1
Causes of cost push inflation HEY , Y
1. Wage price spiral: E.g. As aggregate demand , DPI
causes price levels which then causes wage rates
which then causes in price levels, which causes further
increase in wage demand, and so on….
2. increase in energy prices, e.g. oil, electricity etc
3. decrease in factor productivity, causing increase in AC
4. Imported inflation, especially when imported raw
materials become expensive become expensive, or
when exchange rate depreciates.
5- 9inIR→TinGB→coPT→tI→tAs→RP

SIR SOHAIB ALAVI [email protected] Typed by Ahmed Mansoor

A level LGS Gulberg (2020-22)
 Negative consequences of inflation

Internal

lenders
eg pensioners
1. Salaried and fixed income people worse off salaries [ R )
normally
fined year for a
)
2. Creditorspavers
T
lose as Real interest rate ( RI R NI = -

3. Government worsens off as its tax revenue falls due to falling profits and
Workers are
←employment due to cost push inflation
worse
off 4. Production of consumer(goods as capital goods are now more expensive and
hence more profitable misallocation
of resources)
5. Producer suffers if there is cost push inflation (profits )
( 6. Hoarding and black market eg sugar
7. in investment as cost of production
.

8. Expectation of inflation wage price spiral

9. Store of value weakened due to inflation; standard of deferred payments weakened
as real interest rate falls; medium of exchange weakens when hyperinflation

External

1. Balance of payment as export prices exports (export – import)

Demand for local currency
'

leading to Current Account →

2. Exchange rate as export prices exports depreciation of local
currency exchange rate
international trade
which is worse ? (conclusion) heavilythat / is reliant dependant
GDP + tuneupI
on

F- atonal consequences for

will be bad
an eco
's internal
effect ( at Bo
Pt
→
→

ripple effect country & it is not trade trade

on
because that will
dependant
,
cause

heavily
a on

cost push
inflation
-

will be severe islagflation

)
If county is enpoueiueing
a
internal
Positive consequences of inflation then
,

consequences

Even though high inflation is caused by supply side factors sometimes 𝜋 is beneficial for
an economy

1. Stimulating or increasing output: low and stable Demand pull Inflation will cause high
profits for firms which will cause firms production
2. Employment : low DPI causing in profits and output will naturally cause in
employment as demand for labor
3. N•q;inae
in debt burden: in inflation → real interest rate (net interest rate – 𝜋 ) which
will lead to in debt burden

Factor affecting consequences of inflation

1. Causes of inflation: demand pull inflation may be good but cost push inflation is
always bad
2. Rate of inflation: high rate always bad, while low rate can be good

SIR SOHAIB ALAVI [email protected] Typed by Ahmed Mansoor

A level LGS Gulberg (2020-22)
 3. Stable or accelerating inflation: stable inflation a sign if certainty, accelerating
inflation a sign of uncertainty for the business, trader & investor and problem for
consumer

Indexation: when the growth of any variable is fixed with the rate of inflation e.g. Wage
growth if 𝜋 = 10 % in 2020 and a company has indexed its employees wage, then wage will
also by 10 % so pp does not fall (real wage constant)

Note: Real wage= Net wage – 𝜋

time
general price
level
of eco over
period of
.

te
a
in
an

Deflation i. -

Good deflation Bad deflation

• This occurs due to increase in • This occurs due to decrease in
aggregate supply of the economy. aggregate demand of an economy
• This results in price stability, and may • This results in fall in spending and
even lead to fall in prices in the long hence profits, which leads to low
run, while economy’s productive demand for workers, which increases
capacity and output rise unemployment and lowers wages,
• This occurs in the long run when the which causes further reduction in
economy’s structure is strong spending and living standards, which
• Supply-side policies can cause this lowers investment in the economy,
and all of this results in a fall in
Rare
very
• .

output/RGDP, or recession
• It signals the beginning of a recession,
if it lasts for a few months
• Govt tries to correct this deflation
through expansionary fiscal (lowering
taxes) and monetary policies
(lowering interest rates)
AS1
A21
Price Price AS1
level level

AD1
AD2

Output/RGD
AD
P

Output/RGD
P

SIR SOHAIB ALAVI [email protected] Typed by Ahmed Mansoor

A level LGS Gulberg (2020-22)