4.8 Inflation & Deflation (Cambridge (CIE) IGCSE Economics)

Demand-pull inflation is caused by excess demand in the economy due to increases in consumption, investment, government spending or net exports.

Aggregate demand is the sum of consumption, investment, government spending and net exports.

If the central bank lowers interest rates, increased borrowing can lead to higher consumption and investment, causing demand-pull inflation.

Cost-push inflation is caused by increases in the costs of production like labour, raw materials or falling productivity.

Cost-push inflation occurs when higher production costs or falling productivity reduce supply, leading to higher prices.

If trade unions negotiate higher wages, the increased labour costs for firms can cause cost-push inflation.

Inflation creates uncertainty for firms, forcing them to change prices frequently and delaying investment decisions.

Inflation decreases consumers' purchasing power and reduces the real value of savings.

Inflation erodes international competitiveness but also erodes the value of government debt as repayments are worth less.

Workers demand higher wages to compensate for reduced purchasing power, but if wage increases don't match inflation, motivation can fall.

True.

Governments typically want low inflation, around 2–3%, as it signals economic growth.

The two causes of deflation are demand-side deflation and supply-side deflation.

Demand-side deflation is caused by a fall in aggregate demand in the economy.

If any component of real GDP (consumption, investment, government spending, net exports) decreases, it can lead to demand-side deflation.

With falling output during demand-side deflation, unemployment increases as fewer workers are required.

Falling output and rising unemployment cause consumers to lose confidence and reduce consumption during demand-side deflation.

Debt feels more burdensome during deflation as the real value of debt increases while the price level falls.

Supply-side deflation is caused by increases in productive capacity and supply in the economy.

Supply-side deflation occurs due to increases in the quantity or quality of factors of production like labour, capital, etc.

With rising output during supply-side deflation, more workers are required so unemployment falls.

Falling prices and rising output cause consumers to gain confidence and increase consumption during supply-side deflation.

False.

While demand-side deflation is undesirable, supply-side deflation that increases output is desirable for an economy.

Persistently falling prices can make exports more attractive to foreign buyers during deflation.

Contractionary demand-side policies like fiscal and monetary policy aim to reduce aggregate demand to tackle demand-pull inflation.

Contractionary fiscal policy includes:

• Increasing corporate tax

• Increasing personal income tax

• Decreasing government spending

Contractionary monetary policy raises interest rates or reduces the money supply to decrease spending and inflation.

Two drawbacks of contractionary policies include:

• Contractionary policies decrease national output

• Contractionary policies lead to lower employment in the economy

Supply-side policies that improve productivity and reduce costs aim to tackle cost-push inflation.

Supply side policies used to tackle inflation include:

• Deregulation

• Reformation of the labour market

• Subsidising key industries

• Providing increased education and training

Expansionary fiscal policy increases government spending or reduces taxes to boost household income and consumption.

One example of expansionary monetary policy includes:

• Lowering interest rates

• Depreciating the exchange rate

• Increasing the use of quantitative easing

One drawback of expansionary monetary policy includes:

• It increase income inequality as the poorest households may not benefit

• It may cause demand pull inflation

False.

Supply-side policies do not directly address deflation.