Describe Inflation and its causes and effects using economic models

1. Describe Inflation and its causes and effects using economic models Level 2 Economics: 2.1 ( AS90794) 4 Credits

2. With the permission of Pearson Education, the publisher, and Robin Sutton, the author, this presentation is based on information written in Economic Issues for New Zealand. • Supplementary tasks and activities can be found in the text book and supporting workbook. • NZCETA has approval from NZQA to use their materials in the development of this resource.

3. Achievement Criteria

4. 1. Describe Inflation • The description of inflation will involve a selection from: • the difference between a persistent rise in the price level and a price rise in a particular market • inflation, deflation and disinflation.

5. 2. Economic Models • The use of economic models will involve a selection from: • the quantity theory of money to illustrate the relationship between the money supply and the rate of inflation • the basic AS/AD model to illustrate cost-push and demand-pull inflation (an understanding of the shapes of the curves is not required).

6. 3. Causes of Inflation • The causes of inflation will involve a selection from: • the relationship between the money supply and the rate of inflation • cost-push and demand-pull inflation • interest rates and the rate of inflation • the business cycle.

7. 4. Effects of Inflation • The effects of inflation will involve a selection from: • impact of inflation on firms and households • impact of inflation on trade and growth.

8. 1. Describe Inflation

9. General Price Level An average of all prices in the economy usually measured by an index

10. General or Persistent Price Rise An increase in the average of all prices in the economy measured by an index, such as the CPI

11. Individual Price Rise An increase in the price in a single market, eg the price of petrol increases This is not inflation

12. Inflation A sustained increase in the general price level eg inflation rate = 3.2%

13. Disinflation A slowing in the rate of increase in the general price level, a fall in the rate of inflation eg inflation rate fallen from 3.2 % to 2.9%

14. Deflation A fall in the general price level eg inflation rate is – 0.5%

15. % changein Price Level 1 2 3 4 Years Activity 0

16. % changein Price Level 1 2 3 4 Years Activity answers 0

17. NZ Inflation: 1970-2006

18. Since 1990 CPI inflation has averaged around 2.5%. This compares with averages of around 12% in the 1970s and 11% in the 1980s.

19. 2. Economic Models and Causes of Inflation

20. Quantity Theory of Money If more money is injected into the economy there will be an increase in prices in the economy. This injection will be spent by people who receive it. They buy more goods and services, increasing demand, causing demand-pull inflation.

21. Quantity Theory of Money (2) The crude quantity theory of money is written as follows: P ∝ M That is, the price level (P) is proportional (∝) to the money supply, the amount of money in the economy (M) It is assumed that V (velocity of circulation) and Q (real output) are constant

22. Increase in the money supply For wages / price spiral to operate, there has to be an increase in the money supply to allow employee to receive their new wages. M x V = P x Q Any increase in money supply would lead directly to an increase in price level. If wages increase, people will spend more which will increase aggregate demand and therefore the price level inflation.

23. Demand Pull Inflation Any inflation that results from an increase in demand is calleddemand-pull inflation Causes: • Increased income • Decreased income tax • Increased optimism about the future • Decreased tendency to save • Consumers expect prices to rise in the future • More money in the economy

24. Activity Draw an AD / AS graph to illustrate demand pull inflation

25. Y Y1 Demand Pull Inflation

26. Cost Push Inflation Any inflation that results from a decrease in aggregate supply is called cost-push inflation Causes: • Increased cost of raw materials • Increased wages • Failure to replace capital goods as they age reducing its productivity or increasing its maintenance costs • Falling productivity of workers

27. Activity Draw an AD / AS graph to illustrate cost push inflation

28. AS 1 AS PL1 PL AD Y1 Y Real output Y1 Y Cost Push Inflation

30. Changes in Interest Rates • Influenced by the amount of economicactivity. • If the Reserve Bank is concerned that economic activity is verystrong and may cause dramatic increases in ADand therefore inflation, interest rates / OCR will rise in order to reduce demand. (graph this) • People/Businesses will have less money to spend / invest or will be more tempted to put their money into a savings account. Reducing inflationary pressures

31. AS PL1 PL2 AD1 AD2 Increase in Interest Rates Decreased Inflationary pressures

32. Effect of an Increase in Interest Rate (OCR) • Decrease in household and business spending • Increased household savings • Decreased investment • Increased unemployment due to AD decreasing • Decreased government revenue due to decreased tax take • Increase in exchange rate due to increased demand for $NZ • Exports more expensive and less competitive • Imports cheaper • Decreased economic activity • Decrease inflationary pressures

33. Changes in Interest Rates Influenced by the amount of economic activity If the Reserve Bank is concerned that economic activity is veryweakand may cause dramatic decreases in ADInterest Rates / OCR will fallin order to increase demand, economic activity and growth (graph this). People/Businesses will have more money to spend / invest or will be less tempted to put their money into a savings account.

34. Decrease in Interest Rates AS PL2 PL1 AD2 Increased Inflationary pressures AD1

35. Effect of a Decrease in Interest Rate • Increase in household and business spending • Decreased household savings • Increased investment • Decreased unemployment due to AD increasing • Increased government revenue due to increased tax take • Decrease in exchange rate due to decrease demand for $NZ • Exports cheaper and more competitive • Imports more expensive • Increased economic activity • Increased inflationary pressures

37. The Business Cycle / Depression

38. The Business Cycle (1) During a recovery / expansion period, investment increases as producers undertake new investment to meet growing demand However, producers eventually have in place the investment they need and so they slow or stop new investment

39. The Business Cycle (2) This slowing in investment means that there is a reduction in total demand in the economy GDP = C + I + G + ΔR + (X – M) I term falls Therefore incomes start to fall and so total demand in the economy falls. Workers in the investment industries for example, start to lose their jobs, eg building industry employees

40. The Business Cycle (3) Firms now reduce their output because of falling demand This process stops when investment, employment and growth are at a minimum Extra investment is needed at this point to maintain production because of depreciation, etc and so the next upturn is created

41. Business Cycle (continued) BOOM: real GDP is rising strongly, high employment, AD and output, strong inflationary pressures PEAK: growth still occurring but rate of growth slows, lower inflationary pressures RECESSION: real GDP falls, increasing unemployment, decreasing output and sales, very low levels of inflation DEPRESSION: very low economic activity, little or no inflation RECOVERY: real GDP begins to rise. Recovery depends on rate of rising AD, inflationary pressure begin to rise.

42. Activity • Draw a business cycle and label the different levels of inflation you predict will occur at each phase of the cycle

43. 3. Effects of inflation

44. Effects of inflation on firms • increases costs of production • exports less competitive • makes it harder to reinvest • distorts price signals and makes planning more difficult • encourages speculative rather than productive investment

45. Effects of inflation on households • reduced purchasing power • discourages saving • encourages borrowing • creates fiscal drag (due to higher tax bracket) • has unequal effects (speculators win, fixed income [beneficiaries] lose)

46. Effects of inflation on trade Quantity of goods & services that we export will fall as overseas buyers purchase goods from other countries that are relatively less expensive fall in employment in export sector worsens current account as NZ priced goods less competitive on world markets

47. Effects of inflation on trade (2) Inflation high interest rates to bring inflation down foreign capital is attracted to NZ Investments high exchange rates. The foreign currency will be converted to NZ$ increasing value of NZ$. • import payments • exports receipts Worsening of the current account

48. Effect of inflation on growth economic growth will fall as productive investment falls (due to higher nominal interest rates) and speculative investing rises as capital gains easy to achieve in high inflation environment

49. Impact on inflation of changes in factor costs if firms costs of production rise AS falls causing cost push inflation

50. Impact on inflation of changes in overseas prices eg Higher overseas prices  exporting  less available on local market  cost-push inflation.