Inflation

Inflation:

This is the sustained or persistent increase in the general price level over time

Deflation:

This is the sustained or persistent decrease in the general price level over time

Hyperinflation

Inflation above 25%

Causes of Inflation

• Demand-pull
• • Demand has gone up significantly
• Cost-push
• • Prices go up due to less demand
• Quantity theory of money
• • $MV = PT$
• • Money supply x Income velocity = Price level x Real GDP

Monetarist

Inflation is always is a monetary phenomenon This theory is based on the quality theory of money (QTM).

Money supply income velocity = Price level Real GDP V and T has overline (add later)

Why is inflation bad?

1. Lowers the purchasing power of consumers
2. Inflation increases the nominal rate of interest
3. Loss in international competitiveness
4. Debtors gain and creditors lowers

Inflation is far worse for the economy if it is a shock and therefore unanticipated. If it is anticipated, then firms, workers, and the govt will adjust things accordingly

Wage-price spiral: Once inflation occurs, it starts a process that is difficult to stop.

• Nominal wages increase
• Cost of production increases, leading to cost pull inflation
• Price of final goods increases
• Increase in cost of living
• Trade Unions want a wage increase

1) Some inflation is better than Deflation

• Deflation is associated with a recession and it is very difficult to use macroeconomic tools to correct it.

2) Inflation is more difficult to deal with if it is unstable and prolonged

3_ Unanticipated inflation causes a shock to the economy and is much more difficult to manage

4) Inflation, as compared to trading partners, is important as inflation can affect international competitiveness

5) Managing inflationary expectations is very important in controlling inflation. NZ does this by having an independent central bank and credible monetary policy.