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

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  • What is inflation?

    Inflation is the sustained increase in the general price level of goods/services in an economy.

  • How is the general price level measured?

    The general price level is measured by checking the prices of a basket of goods and services that an average household purchases each month.

  • What is the CPI?

    The CPI (consumer price index) is a weighted index of the basket of goods and services used to measure inflation.

  • True or False?

    No inflation is better than low inflation.

    False.

    Low inflation is better than no inflation, as it is a sign of economic growth.

  • Define the term deflation.

    Deflation occurs when there is a fall in the general price level of goods and services in an economy.

  • What is disinflation?

    Disinflation refers to a reduction in the inflation rate from a higher level to a lower level, but prices are still rising e.g the rate of inflation falls from 5% to 3%.

  • How is the inflation rate calculated?

    The inflation rate is calculated using the consumer price index.

    Formula.

    (New CPI - Old CPI) ÷ Old CPI x 100

  • Define the base year used in the CPI.

    The base year for the CPI is the year in which the index is set to 100.

  • True or False?

    The CPI includes all goods and services.

    False.

    The CPI only includes a basket of around 700 goods and services that an average household purchases.

  • What are the two main causes of inflation?

    The two main causes of inflation are demand-pull inflation and cost-push inflation.

  • Define demand-pull inflation.

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

  • What are the components that make up aggregate demand?

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

  • Give an example of demand-pull inflation.

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

  • Define cost-push inflation.

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

  • What causes cost-push inflation?

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

  • Give an example of cost-push inflation.

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

  • How does inflation impact firms?

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

  • How does inflation impact consumers?

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

  • How does inflation impact the government?

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

  • How does inflation impact workers?

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

  • True or false?

    Some inflation is desirable for economic growth.

    True.

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

  • What are the two causes of deflation?

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

  • Define demand-side deflation.

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

  • How does demand-side deflation occur?

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

  • What is a consequence of demand-side deflation?

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

  • How does demand-side deflation impact consumers?

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

  • How does demand-side deflation impact debt?

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

  • Define supply-side deflation.

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

  • What causes supply-side deflation?

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

  • What is a consequence of supply-side deflation?

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

  • How does supply-side deflation impact consumers?

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

  • True or false?

    Both types of deflation are undesirable.

    False.

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

  • How does deflation impact exports?

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

  • What policies best address demand-pull inflation?

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

  • Give an example of a contractionary fiscal policy.

    Contractionary fiscal policy includes:

    • Increasing corporate tax

    • Increasing personal income tax

    • Decreasing government spending

  • Define contractionary monetary policy.

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

  • What are two drawbacks of contractionary policies?

    Two drawbacks of contractionary policies include:

    • Contractionary policies decrease national output

    • Contractionary policies lead to lower employment in the economy

  • What policies best address cost-push inflation?

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

  • State one supply-side policy used to tackle inflation.

    Supply side policies used to tackle inflation include:

    • Deregulation

    • Reformation of the labour market

    • Subsidising key industries

    • Providing increased education and training

  • Define expansionary fiscal policy.

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

  • State one example of expansionary monetary policy.

    One example of expansionary monetary policy includes:

    • Lowering interest rates

    • Depreciating the exchange rate

    • Increasing the use of quantitative easing

  • What is one drawback of expansionary monetary policy?

    One drawback of expansionary monetary policy includes:

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

    • It may cause demand pull inflation

  • True or False?

    Supply-side policies address deflation.

    False.

    Supply-side policies do not directly address deflation.