Price Level: Inflation (AQA A Level Economics)

Inflation, Deflation & Disinflation

• Inflation is the sustained increase in the average price level of goods/services in an economy  

• Deflation occurs when there is a fall in the average price level of goods/services in an economy

  • Deflation only occurs when the percentage change in prices falls below zero %

• Disinflation occurs when the average price level increases but at a decreasing rate than before

  • These figures demonstrate disinflation:  Y1 = 5%  Y2 = 4%  Y3 = 2%

Diagram: UK Inflation, Disinflation and Deflation

Causes of Inflation

• An increase in the average prices in an economy can be caused by demand pull inflation or cost push inflation

1. Demand pull inflation

• Demand pull inflation is caused by excess demand in the economy

• Aggregate demand (AD) is the sum of all expenditure in the economy

  • AD = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)

Diagram: Demand Pull Inflation

Diagram analysis

• If any of the four components of AD increase, there will be a shift to the right of the AD curve from AD₁ → AD₂

• At the original price (AP₁), there is now a condition of excess demand in the economy (extend the dotted line across until it hits the new demand curve to identify the excess demand)

• Prices for goods/services are bid up from AP₁ → AP₂

• Demand pull inflation has occurred

• If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms and consumers

  • This will result in an increase in consumption and investment

  • It is likely to lead to a form of demand-pull inflation

2. Cost push inflation

• Cost push inflation is caused by increases in the costs of production in an economy

Diagram: Cost Push Inflation

Diagram analysis

• If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in productivity, there will be a shift to the left of the SRAS curve from SRAS₁→SRAS₂

• At the original price (AP1), there is now a condition of excess demand in the economy

• As prices rise, there is a contraction of AD and an extension of SRAS

• Prices for goods/services are bid up from AP₁→AP₂

• Cost push inflation has occurred

The Quantity Theory of Money

• The Monetarist model, strongly influenced by economists like Milton Friedman, believe that an increase in money supply can lead to inflation, while a decrease can result in deflation

• Monetarists believe that central banks should focus on controlling the money supply to achieve price stability. They argue that a steady and predictable growth rate in the money supply can contribute to stable economic conditions

• Fisher's equation of exchange MV = PQ and the Quantity Theory of Money is a key component of the monetarist model

  • Equation of exchange (MV = PQ)

    • M represents money supply in the economy

    • V signifies the velocity or speed at which money circulates in the economy. It measures how many times, on average, a unit of currency changes hands in a given time period

    • P represents the general price level of goods/services in the economy. It reflects the average prices of a basket of goods

    • Q stands for the real output or quantity of goods/services produced in the economy
      

• All other things being equal, if the velocity of circulation is constant, the quantity theory of money based on Fisher’s equation of exchange, MV=PQ, predicts that an x% increase in the money supply will always cause an x% increase in nominal national income, i.e there will be inflation

The Relationship Between Expectations and Changes in the Price Level

• Expectations refer to individuals' anticipations of future economic conditions

  • Often, if consumers expect prices to fall, they will delay purchases in the hope of purchasing good/services at lower prices

    • The delay in consumption then helps prices to fall!

  • Often, if consumers expect prices to rise, they will rush to purchase good/services at lower prices before they rise

    • The increase in consumption then helps prices to rise!

• Inflation psychology refers to the psychological factors that influence how individuals and businesses anticipate and react to inflation

Types of Inflation Psychology

The Consequences of Inflation

• The consequences of inflation are different for different stakeholders in the economy

• The consequences are also dependent on the household level of wealth and income 

The Impact of Inflation on Different Stakeholders