Problems of deflation

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Deflation is defined as a fall in the general price level. It is a negative rate of inflation. The problem with deflation is that often it can contribute to lower economic growth. This is because deflation increases the real value of debt – and therefore reducing the spending power of firms and consumers. Also, falling …

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Different types of inflation

different-types-of-inflation

Inflation means a sustained increase in the general price level. The main two types of inflation are

  1. Demand-pull inflation – this occurs when the economy grows quickly and starts to ‘overheat’ – Aggregate demand (AD) will be increasing faster than aggregate supply (LRAS).
  2. Cost-push inflation – this occurs when there is a rise in the price of raw materials, higher taxes, e.t.c

We can also categorise inflation by how fast the price increases are, such as:

  • Disinflation – a falling rate of inflation
  • Creeping inflation – low, but consistently creeping up.
  • Walking/moderate inflation –  (2-10%)
  • Running inflation (10-20%)

Types include of inflation include

different-types-of-inflation

1. Demand-pull inflation

This occurs when AD increases at a faster rate than AS. Demand-pull inflation will typically occur when the economy is growing faster than the long-run trend rate of growth. If demand exceeds supply, firms will respond by pushing up prices.

A simple diagram showing demand-pull inflation

ad increase - inflation
The UK experienced demand-pull inflation during the Lawson boom of the late 1980s. Fuelled by rising house prices, high consumer confidence and tax cuts, the economy was growing by 5% a year, but this caused supply bottlenecks and firms responded by putting up prices. Therefore the inflation rate crept up.

lawson-boom-inflation-growth

This graph shows inflation and economic growth in the UK during the 1980s. High growth in 1987, 1988 of 4-5% caused an increase in the inflation rate. It was only when the economy went into recession in 1990 and 1991, that we saw a fall in the inflation rate. See: Demand-pull inflation.

2. Cost-push inflation

This occurs when there is an increase in the cost of production for firms causing aggregate supply to shift to the left. Cost-push inflation could be caused by rising energy and commodity prices. See also: Cost-Push Inflation

Diagram showing cost-push inflation.
SRAS-shift-left

Example of cost-push inflation in the UK

UK inflation- 2017

In early 2008, the UK economy entered a deep recession (GDP fell 6%). However, at the same time, we experienced a rise in inflation. This inflation was definitely not due to demand-side factors; it was due to cost push factors, such as rising oil prices, rising taxes and rising import prices (as a result of depreciation in the Pound) By 2013, cost-push factors had mostly disappeared and inflation had fallen back to its target of 2%. After the June 2016 Brexit referendum, Sterling fell another 13% causing another period of cost-push inflation in 2017.

Sometimes cost-push inflation is known as the ‘wrong type of inflation‘ because this inflation is associated with falling living standards. It is hard for the Central Bank to deal with cost push inflation because they face both inflation and falling output.

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Who are the winners and losers from inflation?

winners-losers-inflation

Inflation is a continues rise in the price level. Inflation means the value of money will fall and purchase relatively fewer goods than previously. In summary: Inflation will hurt those who keep cash savings and workers who have fixed wages Inflation will benefit those with large debts, who with rising prices find it easier to …

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Inflation: advantages and disadvantages

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Readers Question: what are the advantages and disadvantages of inflation? Inflation occurs when there is a sustained increase in the general price level. Traditionally high inflation rates are considered to be damaging to an economy. High inflation creates uncertainty and can wipe away the value of savings. However, most Central Banks target an inflation rate …

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Policies to reduce inflation

Inflation is a period of rising prices. The primary policy for reducing inflation is monetary policy – in particular, raising interest rates reduces demand and helps to bring inflation under control. Other policies to reduce inflation can include tight fiscal policy (higher tax), supply-side policies, wage control, appreciation in the exchange rate and control of the money supply. (a form of monetary policy).

annual-inflation uk

Summary of policies to reduce inflation

  • Monetary policy – Higher interest rates. This increases the cost of borrowing and discourages spending. This leads to lower economic growth and lower inflation.
  • Tight fiscal policy – Higher income tax and/or lower government spending, will reduce aggregate demand, leading to lower growth and less demand-pull inflation
  • Supply-side policies – These aim to increase long-term competitiveness, e.g. privatisation and deregulation may help reduce costs of business, leading to lower inflation.

Policies to reduce inflation in more details

1. Monetary Policy 

In the UK and US, monetary policy is the most important tool for maintaining low inflation.  In the UK, monetary policy is set by the MPC of the Bank of England. They are given an inflation target by the government. This inflation target is 2%+/-1, and the MPC use interest rates to try and achieve this target.

The first step is for the MPC to try and predict future inflation. They look at various economic statistics and try to decide whether the economy is overheating. If inflation is forecast to increase above the target, the MPC are likely to increase interest rates.

Increased interest rates will help reduce the growth of aggregate demand in the economy. The slower growth will then lead to lower inflation. Higher interest rates reduce consumer spending because:

  • Increased interest rates increase the cost of borrowing, discouraging consumers from borrowing and spending.
  • Increased interest rates make it more attractive to save money
  • Increased interest rates reduce the disposable income of those with mortgages.
  • Higher interest rates increased the value of the exchange rate leading to lower exports and more imports.

Diagram showing fall in AD to reduce inflation

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Base Rates and Inflation

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Base interest rates were increased in the late 1980s / 1990 to try and control the rise in inflation. See also:

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The link between Money Supply and Inflation

money-supply-inflation

Readers Question: When would an increase in the money supply not result in an increase in inflation? In a simplified form. Increasing the money supply faster than the growth in real output will cause inflation. The reason is that there is more money chasing the same number of goods. Therefore, the increase in monetary demand …

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Pros and Cons of Inflation

Readers Question: What are the advantages and disadvantages of inflation? The Government have an inflation target of CPI 2%. This suggests they would rather have moderate inflation than no inflation at all. Advantages of Inflation Deflation is potentially very damaging to the economy and can lead to lower consumer spending and lower growth. For example, …

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Should low inflation be the primary objective of economic policy?

The UK government has given the Bank of England an inflation target of CPI 2 % +/-1. The Bank of England is responsible for using monetary policy (e.g. interest rates)  to achieve this goal of low inflation. But, as well as targeting inflation, the Bank of England also has a wider remit of considering objectives …

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