3.3.4 Low and stable rate of inflation Notes

1. Price stability is a fundamental macroeconomic goal for any economy.
2. As we will discover in this section, when prices remain relatively stable:
   1. Consumers can make confident spending decisions.
   2. Businesses can plan investments effectively.
   3. The overall economy can function more efficiently.

Measuring inflation using the consumer price index (CPI)

1. The CPI is used by economies worldwide to track inflation (or deflation).
2. It does so based on the percentage change in the basket's value over time.

Calculating inflation

With the CPI provided, the inflation rate can be calculated by using this formula:

$$\text{Inflation Rate}=\frac{(100\text{Weighted Price Index}−100​)} \times 100$$

Table 1 above shows the CPI data for an imaginary economy, Econland. The inflation rate for each year can be calculated by using the formula above.

From Year 1 to Year 2:

• CPI in Year 2 = 105
• CPI in Year 1 = 100
• Inflation Rate: $\left( \frac{105 - 100}{100} \right) \times 100 = 5.00\%$

From Year 2 to Year 3:

• CPI in Year 3 = 110
• CPI in Year 2 = 105
• Inflation Rate: $\left( \frac{110 - 105}{105} \right) \times 100 = 4.76\%$

From Year 3 to Year 4:

• CPI in Year 4 = 120
• CPI in Year 3 = 110
• Inflation Rate: $\left( \frac{120 - 110}{110} \right) \times 100 = 9.09\%$

From Year 4 to Year 5:

• CPI in Year 5 = 125
• CPI in Year 4 = 120
• Inflation Rate: $\left( \frac{125 - 120}{120} \right) \times 100 = 4.17\%$

The limitations of the CPI in measuring inflation

Several limitations affect CPI's accuracy as a measure of inflation. Some of these limitations include:

1. Substitution bias:
   1. When prices rise, consumers switch to cheaper alternatives.
   2. CPI uses fixed weights and doesn't capture these changes.
   3. Results in overestimating actual cost increases.
2. Quality changes:
   1. New quality improvements aren't fully reflected.
   2. Therefore, price increases due to quality improvements are counted as inflation.
3. New products:
   1. The CPI basket takes time to incorporate new products and services.
   2. This delay means important consumption changes aren't quickly reflected.
   3. Thus, the index can become outdated in rapidly evolving markets.
4. Regional differences:
   1. CPI uses national average prices that don't reflect local/regional variations.
   2. In reality, living costs can vary significantly between urban and rural areas.
   3. A single national figure may not represent any actual location's experience.

Causes of inflation

There are two types of inflation studied in the IB curriculum: demand-pull inflation and cost-push inflation.

Demand-pull inflation

Demand-pull inflation is represented in the AD-AS model by a rightward shift in the aggregate demand (AD) curve (Figure 1).

1. At initial equilibrium ($E_1$) the market is in balance. The price level is at $PL_1$, and the real output is at $Y_1$.
2. As aggregate demand increases (due to an increase in one of tis components), the AD curve shifts rightward ($AD_1$ → $AD_2$).
3. As a result, price level rises ($PL_1$ → $PL_2$), and output increases ($Y_1$ → $Y_2$). This shows both inflation and economic growth.
4. As seen, higher aggregate demand has pulled prices upwards.
5. Since output cannot expand enough to meet all new demand, demand-pull inflationary pressures rise.

Cost-push inflation

Cost-push inflation is shown in the AD-AS model by a leftward shift of the AS curve (Figure 2).

1. The initial equilibrium ($E_1$) represents normal market conditions. At this point, $AD$ intersects $SRAS_1$, the economy is at price level $PL_1$ and real output $Y_1$.
2. Increased production costs across the economy can create a supply shock, causing the supply curve to shift leftwards ($SRAS_1$ → $SRAS_2$).
3. As the price level rises ($PL_1$ → $PL_2$), the output falls from ($Y_1$ → $Y_2$). This shows stagflation: a situation where there is inflation and falling levels of real output.

Costs of a high inflation rate

High inflation creates several serious problems that can damage an economy's performance and people's well-being. Some of these problems are shown below:

1. Uncertainty makes planning difficult:
   1. Businesses struggle to plan future investments because they can't predict future costs.
   2. Workers don't know if their wages will keep up with rising prices.
   3. Long-term contracts become risky as money loses value over time.
2. Creates unfair winners and losers:
   1. People with savings lose purchasing power as their money becomes worth less.
   2. Borrowers benefit because they repay loans with money worth less than when they borrowed.
   3. Fixed-income earners (like pensioners) suffer as their income buys less over time.
3. Discourages saving:
   1. Money loses value the longer you hold it, so it is not beneficial to save.
   2. Thus, people rush to spend rather than save, creating even more inflation.
   3. Makes it harder for people to save for big purchases or retirement.
4. Hurts international trade
   1. Higher domestic prices make exports more expensive.
   2. As a result, foreign buyers switch to cheaper alternatives from other countries.
   3. Trade deficit often worsens as a result.
5. Slows economic growth:
   1. Investment decreases due to uncertainty.
   2. Resources get wasted trying to protect against inflation.
   3. Overall productivity falls as businesses focus on coping with inflation rather than improving efficiency.

Causes of deflation

Deflation can be caused due to either an AD curve shifting left or an SRAS curve shifting right:

1. As the AD curve shifts left ($AD_1$ → $AD_2$) due to (for example) reduced spending in the economy, price levels go down ($PL_1$ → $PL_2$) together with real output ($Y_1$ → $Y_2$).
2. As the SRAS curve shifts right ($SRAS_1$ → $SRAS_2$) due to (for example) lower production costs or higher productivity, price levels go down $PL_1$ → $PL_2$, while output increases ($Y_1$ → $Y_2$).
3. These shifts can be visualised in Figure 3 below.

Disinflation and deflation

1. Deflation, on the other hand, is a sustained decrease in the general price level over time.
2. While deflation is indicated by a negative inflation rate, disinflation can still result in a positive inflation rate.

Costs of deflation

Deflation can create serious problems throughout the economy, particularly when caused by falling demand. Among these problems are:

1. Deferred consumption and investment
   1. People and firms wait to buy because they expect lower prices tomorrow.
   2. This waiting reduces current aggregate demand, forcing prices even lower.
   3. This creates a self-reinforcing downward spiral of falling demand and prices.
2. Policy ineffectiveness:
   1. Traditional monetary policy stops working at zero interest rates.
   2. Price expectations (for future prices to decrease) become hard to change once deflation is expected.
   3. This makes it very difficult for government to stimulate economy and stop deferred consumption.
3. Association with high levels of cyclical unemployment and bankruptcies:
   1. Falling prices mean falling revenues for businesses.
   2. Companies must cut costs, usually starting with workers, which raises unemployment.
4. Increase in the real value of debt:
   1. Money owed becomes worth more in real terms over time
   2. Fixed loan payments take a larger share of shrinking revenues, which makes it harder to service debts
5. Uncertainty:
   1. Business planning becomes difficult.
   2. Investment decisions are postponed.
   3. Future revenue predictions become unreliable.
6. Redistributive effects:
   1. Savers gain purchasing power unfairly while debtors suffer.
   2. Workers with fixed wages gain while businesses struggle with costs.
7. Inefficient resource allocation:
   1. Companies focus on survival rather than innovation.
   2. Resources get spent on coping with deflation instead of productive investment.
   3. Economic growth potential is wasted.