10.1 Causes of Inflation
Transcript of 10.1 Causes of Inflation
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Inflation Measurement and Causes
AS Economics
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Areas to focus on
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Key Issues
The meaning of inflation
Measuring the general price level
Deflation and hyperinflation Causes of inflation (demand pull and cost push)
Controlling inflation demand and supply-side
policies
Recent trends in UK inflation
Why has inflation in the UK remained so low?
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Defining inflation
Inflation is a sustained increase in the average
price level of a country.
The rate of inflation is measured by the annualpercentage change in the level of prices as
measured by the consumer price index.
A sustained fall in the general price level is
called deflation in this situation, the rate ofinflation becomes negative.
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What are the main causes of inflation?
Watch this & make notes
on what have been the
causes of inflation
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Two types of causes of inflation
Demand pull inflation
Cost push inflation
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Demand pull inflation
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Demand-pull inflation
Occurs when there is excess AD i.e. when there is a
positive output gap (actual GDP > Potential GDP)
Businesses respond to high demand by raising prices to
increase their profit margins
Demand-pull inflation is associated with the boom
phase of the cycle (when SRAS becomes inelastic)
The main causes of demand pull inflation
Very fast growth of demand for credit / borrowing
High levels of consumer spending
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Draw a Classical AD/AS diagram
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Draw a Classical AD/AS diagram
Price Level
Real National
Output
Y1
LRAS
0
AD
What would happen if
there was an increase in
AD in the SHORT RUN?
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Draw a Classical AD/AS diagram
Price Level
Real National
Output
Y1
LRAS
Y2
AD1
0
AD
SRAS
How can an
economy
operate
beyond its
Fullemployment
level?
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PPF represents an economys capacity!
How can an
economy
operate
beyond its
Fullemployment
level?
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Draw a Classical AD/AS diagram
Price Level
Real National
Output
Y1
LRAS
Y2
AD1
0
AD
SRAS
In the SR
theeconomy
can work
overtime, at
a slightly
higher cost
(overtime)
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Draw a Classical AD/AS diagram
Price Level
Real National
Output
Y1
LRAS
Y2
AD1
0
AD
SRAS
In the LR,
workers are notwilling to
sacrifice Leisure
time for more
overtime. But
still have high
wage
expectations.demand pull
inflation
SRAS2
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To your notes..
Draw the AD/AS diagram (s) and
add your own explanation of whathappens
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Main causes of demand pull inflation
A depreciation .
A reduction in direct or indirect taxation
Rapid growth of the money supply
Rising consumer confidence
Faster rates ofeconomic growth in other countries
How can
each of
thesecause
inflation?
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Main causes of demand pull inflation
A depreciation of the exchange rate increases the price of
imports and reduces the foreign price of UK exports
A reduction in direct or indirect taxation - consumers will
have more disposable income causing demand to rise
Rapid growth of the money supply as a consequence of
increased bank and building society borrowing
Rising consumer confidence and an increase in the rate of
growth of house prices
Faster rates of economic growth in other countries
providing a boost to UKexports overseas (an injection of
AD)
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Cost push inflation
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Cost Push Inflation
Occurs when costs of production are increasing
Causes:
External shocks (commodity price fluctuations)
A depreciation in the exchange rate
Acceleration in wages
Leads to inward shift in SRAS curve
Firms raise prices to protect their profit margins better able todo this when market demand is price inelastic
Wages often follow prices
A rise in inflation can lead to rising inflationary expectations
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Draw an Classical AD/AS diagram
Price Level
Real National
Output
Y1
LRAS
0
AD
What would happen if
there was an inward shift
of the SRAS?
SRAS1
SRAS2
Y2
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Wage inflation in the UK economy
Annual percentage change in earnings and consumer prices
Earnings and prices
Average earnings Consumer Price Inflation [ar 12 months]Source: Reuters EcoWin
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06
Percent
0
1
2
3
4
5
6
7
8
9
10
11
Consumer price inflation
Average Earnings
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Cost push inflation falling SRAS
Price Level
Real NationalOutput
LRAS
SRAS
Yfe
SRAS2
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Illustrating cost-push inflation
Price Level
Real NationalOutput
LRAS
SRAS
Yfe
AD1
Y1Y2
P2
Pe SRAS2
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Costs and Consequences of Inflation
Money loses its value and people lose confidence in
money as the value of savings is reduced
Inflation can get out of control - price increases lead to
higher wage demands as people try to maintain their
living standards. This is known as a wage-price spiral.
Consumers and businesses on fixed incomes lose out
because the their real incomes falls - employees in poor
bargaining positions lose out
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Consequences of growing inflation
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Costs and Consequences of Inflation
Inflation can favour borrowers at the expense of savers
because inflation erodes the real value of existing
debts
Inflation can disrupt business planning and lead tolower capital investment
Inflation is a possible cause of higher unemployment in
the long term because of a lack of competitiveness
Rising inflation is associated with higher interest rates -
this reduces economic growth and can lead to a
recession
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Explaining low inflation in the UK
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Explaining low inflation in the UK
Several factors explain the absence of inflation
Subdued growth of wages and earnings (below 5%)
Absence of major inflationary shocks such as a sharp jump in
international commodity prices
Success of the Bank of England in keeping aggregate demand
under control through interest rate changes
Much greater competitive pressure in many industries
Strong pound has helped to keep inflation under control
Expansion of technology has helped to reduce costs
Cuts in the prices charged by many of the privatized utilities
Expectations of inflation have fallen!
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The NICE-1990s!
In the 1990s, the UK experienced a non-
inflationary consistently expansionary - or "nice"
- decade; a decade in which growth was a little
above trend, unemployment fell steadily, andcheaper imports allowed consumers to enjoy
rising living standards without the need to ask
for inflationary pay claims
Mervyn King, Governor of the Bank of England
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Interest rates and inflation
Annual percentage change in the UK Consumer Price Index, the inflation target is 2%
Consumer Price Inflation and Interest Rates for the UK
UK Consumer Price Inflat ion [ar 12 months] Base Interest Rates for the UK
Source: Reuters EcoWin
97 98 99 00 01 02 03 04 05 06
Percent
0
1
2
3
4
5
6
7
8
CPI Inflation
Base Interest Rates
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A decline in global inflation
Annual percentage change in consumer prices, source IMF World Economic Outlook
World Inflation
Source: Reuters EcoWin
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
PercentperAnnum
0
5
10
15
20
25
30
35
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Reasons for continued low inflation
Success of Bank
ofEngland in
controlling AD
Strong exchange
rate has kept
import prices low
Effects of
globalisation
cheaper imports
Rising
productivity & new
technology
A fall in workers
expectations of
inflation
Increased
competition in
markets
Low Inflation in the UK Economy
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Homework
Read article about Economic Cycle
Highlight key issues use 2 different colours
highlight positives & negative issues
Make a summary of the key issues raised
Complete Q 1, 2 & 4 only.
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Further knowledge
http://www.bbc.co.uk/iplayer/episode/b00r92bp/Select_
Committees_Inflation_Report_Committee/
If you are really interested in what happens with the
BoE in managing inflation watch this select committee
meeting.
Listen to this reasons why inflation can be good for
the economy
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Some quick questions
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Inflation Qs
What is meant by Inflation? (2)
Explain how inflation is measured? (2)
Explain how a fall in the rate of unemployment might
effect the rate of inflation? (8 marks)
Using AD/AS analysis, assess the implications of a fall
in AD on the UK economy? (8 marks)