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Inflation and Deflation

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23 views5 pages

Inflation and Deflation

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Saba
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© © All Rights Reserved
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Inflation and deflation

Saturday, February 26, 2022 7:32 PM

Inflation

Increase in the general price level of the country over a period


of time.

1) Selection of a base year


a. Base year needs to have minimum price fluctuation
2) Finding out the spending pattern of the households and
attaching weights
3) Finding out price changes
4) Constructing a weighted price index (Consumer price
index) or calculate weighted price change

Causes of inflation

1) Demand pull inflation


Inflation could be caused by excess demand in the economy
referred to as demand pull inflation.

An increase in demand could occur due to an in consumer


spending, investment, and government spending or net exports.

2) Cost push inflation

Section IV Government and macroeconomy Page 1


Inflation could be caused by an increase in the prices of the
costs of production referred to as cost push inflation. Higher
cost of production will reduce aggregate supply in the economy
forcing up the price.

Wage-price spiral

Consequences of inflation

1) Purchasing power of fixed income earners fall


2) Distortion in the distribution of the income
a. Lenders lose
b. Borrowers gain
Lender lent 1 million rupees.
Borrower purchased a car at the start of the year for 1 million
rupees.
At the end of the year, the car is worth 1.2 million rupees. The
borrower has to return 1 million Rupees.
Lender loses
Borrower gains.
Lenders should have an anticipated inflation rate. They try to keep
the lending rate equal to anticipated inflation rate.
Unanticipated inflation is the actual problem.

3) Imposition of extra costs on firms


a. Menu cost (costs in altering prices in catalogues)
i. Cost of deciding the new prices
ii. Cost of printing
iii. Cost of sending the catalogues
iv. Amending prices on websites
Section IV Government and macroeconomy Page 2
iv. Amending prices on websites
v. The cost of advertising the new prices.
vi. Cost of dealing with annoyed customers
b. Shoe-leather cost
i. The resources wasted when inflation encourages people to
reduce their money holdings.
In order to reduce the shoe leather cost, the business has to
involve in active cash management.
4) Inflation creates uncertainty:
5) Inflationary noise
6) Adverse effects on Balance of Payments:
7) It can cause a fiscal drag
Fiscal drag is a situation where the tax rate slabs are not
updated in line with the inflation rate of the economy. This
makes the people to pay a higher rate of taxes if their incomes
are increased by their employers.

Beneficial effects of mild and low inflation:


Inflation rate should be:
• Low
• Stable, not fluctuating
• It should be below rival countries

☺ Firms are likely to expand


☺ Real burden of debt will fall.
☺ It will prevent some unemployment.

Section IV Government and macroeconomy Page 3


DEFLATION:
Deflation refers to a general and persistent decrease in the price of
goods and services over a specific period of time, usually a year.

CAUSES OF DEFLATION:

1. Deflation from supply-side of the economy:


The deflation resulting from the supply-side of the economy is
termed as “good deflation”.

2. Deflation from demand-side of the economy:


Deflation can result from a decline in aggregate demand of the
economy. Consumers expecting lower price in future may postpone
their purchase, hence firms are likely to produce less output and
would fire their employees. This will further decrease the
aggregate demand of the economy. The deflation rising from the
demand side of the economy is termed as ‘bad deflation’.

CONSEQUENCES OF DEFLATION:
Effects of good deflation:
It can reduce current account deficit if the demand for exports and
imports is elastic. If the fall in price level is not offset by increase in
the exchange rate then it will may increase current account surplus.
It may be associated with rise in output and employment.
Effects of bad deflation:
Section IV Government and macroeconomy Page 4
Bad deflation is likely to cause a rise in unemployment and lower
output. It is also likely to discourage investment which will reduce
productive capacity and endanger future economic growth.

Contractionary demand side policies

Section IV Government and macroeconomy Page 5

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