A Low and Stable Rate of Inflation Costs of Inflation: - Loss of Purchasing power if your job isnt directly linked

d to inflation then you wont be able to buy as many goods or services - Effect on saving If you have interest on savings and the inflation rate rises above that, than you will have a negative return. o People are better off spending money rather than saving it, so thats what they end up doing inflation discourages saving - Effects on interest rates if there is a high rate of inflation then banks raise their nominal interests rates in order to keep the real rate that they earn positive - Effect on international competitiveness Exports are less competitive and imports from lower-inflation trading partners are more attractive. o Fewer export revenues and greater expenditure on imports worsening the trade balance. o Could lead to unemployment in the export industry/ industries that compete with imports - Uncertainty firms may be discouraged from investing due to the uncertainty associated with inflation - Labor Unrest it happens when workers feel that their wages and salaries are not keeping up with inflation Deflation: - Its defined as the persistent fall in the average level of prices in the economy - Good inflation comes about from the increase of supply-side policies of the economy and/ or increased productivity o AD/AS diagram is the best way to show it results in an increase of real output - Bad inflation come from the demand side of the economy o AD/ AS diagram is the best way to show this a fall in aggregate demand will result in a decrease in the price level and a decrease of real output - Both result in a fall of the price level Costs of Deflation: - Unemployment: if AD is low, then businesses are more likely to lay off workers o May lead to a deflationary spiral o People wait a long time to buy things in hopes that it will be cheaper later deferred consumption it further reduces AD - Effect on investment: businesses make less profit and it may lead them to lay off workers o Business confidence is low which is likely to result in reduced investment - Costs to debtors: Anyone who has taken a loan suffers as a result of deflation o If profits are low, this may make it too difficult for businesses to pay back their loans and there may be many bankruptcies o It worsens business confidence

How is inflation measured? - Most widely used statistic is the consumer price index (cpi)/ retail price idex (rpi) - Statistics measure what is known as a representative basket when the basket increases, the average price level has risen - What is a representative basket of consumer goods and services? o There is a list of typical goods and services consumed by the average household these are then divided into different categories o The prices of these categories are recorded every month to calculate the change in price of the basket CPI o The categories are weighted depending on how much people normally spend on them Issues Involved in the Measurement of Inflation: - The CPI shows the average household, but that is not applicable to all people o If the national average is used to negotiate wages or pension changes, then they dont accurately reflect the price changes for a particular group o Can be harmful if the group has a higher cost of living than suggest by the national average and beneficial for those whose spending costs are less than average - There may be errors in the collection of data that limit the accuracy of the final results o Its impossible to completely exact and accurate and to take all the stats necessary - Statisticians try to take into account changes in consumption habits by making changes to the basket items can be added or removed o If the items in the basket are changed then it limits the ability of analysts to make comparisons from one time period to another o The quality of goods also change over time - Countries measure their rate of inflation in different ways and include different components makes international comparisons harder - Prices may change for a variety of reasons that are not sustained seasonal variation/ volatile oil prices - The CRI measures the changes in consumer prices but there are other price changes which are important to the judging of economic health and prospects of a country o Economists also measure changes in the prices of the factors of production needed by the economys firms o Some measure the changes in the weighted basket of a large number of different traded commodities, others track a particular category of commodity ike fool, industrial etc o Upward movements in commodity prices are signals of post-push pressures and may be a leading indicators of inflation Causes of inflation:

Demand-Pull Inflation occurs as the result of increasing aggregate demand in an economy o Could exist through any of the components of AD

o Cost-Push Inflation occurs as the result of an increase in the costs of production o Increase in the average price level and a fall in the level of real output o Explained through AS

o Demand-Pull and Cost-Push Inflation Together o Inflation has the tendency to perpetuate itself o Higher price level costs of production will rise o Because the price level increases, workers will negotiate for higher wages and this further increases the costs of production o Thus there will be a higher shift in SRAS o Higher wages give households the illusion that they have more spending power and this might encourage further increases in consumption o Its an inflationary spiral

o Inflation due to excess monetary growth o Milton Friedman Inflation is always and everywhere a monetary phenomenon o Increases in the money supply cause inflation

o Reducing Inflation - Demand-Pull inflation is due to excess aggregate demand best policy is to reduce AD - Gov could use deflationary fiscal policy (increase taxes and lower gov spending) and/ or deflationary monetary policy (raise interest rates and reduce the money supply) - The voting population will not like higher taxes reduces the level of disposable income and the level of consumption - Reduction in gov spending will inevitably impact upon a variety of group in the economy and this may result in less support for the gov - It also takes a long time for fiscal policy to work time lag - Higher interest rates will also harm anybody who has taken a mortgage or a loan - Monetary policy is carried out by central banks most are an independent body whose main goal is the maintenance of a low and stable rate of inflation - Targeting inflation should act as an anchor, holding down inflationary pressure - The more independent the central bank is, the more likely that price stability will be maintained - Monetary policy is considered the most effective way of managing AD in the economy and changes in interest rates are considered the best weapon in the fight against inflation

If inflation is of cost-push nature, then deflationary demand-side policies may bring down the price level, but they will only result in lower national output and are likely to cause unemployment to rise demand-side policies are ineffective and the supply-side policies are the best When inflation does occur, it is hard to distinguish which it is more based upon so policy-makers use a mix of both demand-side and supply-side policies