Inflation is defined as an economic situation where there is a sustained increase in the general price level.

-Anticipated inflation the inflation that the majority of individuals believe will occur. -Unanticipated inflation the inflation that comes as a surprise to individuals in the economy, either higher or lower than the rate anticipated. Measuring Inflation Rate of Inflation = Percentage change of a price index Price Index in year 2 Price Index in year 1 X 100 Price Index in year 1 Degrees of Inflation -Mild Inflation The Price level rises slowly (around 0% to 1%). Most economists feel that a low rate of inflation may stimulate economic expansion. -Creeping Inflation This is a situation where there is a more substantial and persistent increase in GPL, usually referring to an annual rate of inflation of about 6 -7%. -Hyperinflation, Galloping Inflation, Runaway Inflation These are situations where prices rise at a phenomenal rate. Prices are rising so fast that money ceases to be a medium of exchange or as store of value and normal economic activity may break down. Usually the GPL rises by more than 100%. Hyperinflation is frequently associated with social instability and leads to disruptions in the economy. Wage Price Spiral: Interaction of Demand-Pull Inflation and Cost-Push Inflation
General Price Level P2 P1 AS2 AS1

P0 0

AS0

AD0 Q0 Q1 Q2

AD1

AD2

Real National Income

- When costs of production , AS , and AS curve shifts upwards. Firms no. of workers. Govt AD to prevent a recession. AD shifts right. When prices rise, people expect higher prices and bring forward purchases, C, I, shifting AD to the right. Expectations Spiral. If shifts get more rapid a Wage-Price Spiral results. Inflation General Effects of Inflation Internal Effects 1) Loss of confidence in currency 2) Redistribution of income (a) Debtors gain (real value of debts ), Creditors lose out.
Copied from NYJC Econs Lecture Booklet and Mrs Chuas Notes

(b) Fixed income earners lose out. Real income Variable income earners relatively stable or real income (c) When Prices , costs lag behind. Thus Profits for businessman at the expense of workers, creditors (income is fixed) (d) Real Savings , thus, Inflation discourages savings Effects on Production -Mild Inflation may encourage greater production and Investment because of high expected returns. However if it is too rapid, business failures and unemployment may result. -Inflation may reduce efficiency in production. However, rising GPL may force some firms to become more efficient to survive. -Inflation reallocates resources because of the changed relative prices. Effects on Government Finance -Inflation the real cost of borrowing by the govt (as interest rates of govt bond is fixed) -Tax revenue as incomes, profits and prices . Budget surplus may result as govt revenue faster than govt expenditure. -But benefits are short-lived and cant outweigh the costs of inflation. External Effects (a) Effects on the Balance of Trade (Current Balance) -During Inflation, prices , domestic goods become more expensive, thus X -Foreign goods become cheaper than local goods, thus M -This may lead to a trade deficit as (X - M) (b) Effects on Capital Balance - inflation rate, nominal interest rates, short term capital inflows. However, countries with high inflation rates are seen as economically unstable, long term capital outflows, FDI (c) Decrease in Balance of Payments and External Value of currency due to (a) and (b). (d) Increased costs of Foreign Debt Servicing as ER , more local currency is paid even though the amount in the foreign currency is the same. Relationship between Money supply and Inflation Equation of Exchange: MV = PY
Assuming V and Y are fairly stable M is directly proportional to P

M = Money supply in the economy, V = Income velocity of circulation P = general price level expressed as an index, Y = real value of national income Fishers Equation of Exchange: MV = PT T = The number of transactions taken place in a year. M P

Thus, PT = Total Spending

Copied from NYJC Econs Lecture Booklet and Mrs Chuas Notes

Definition

Causes

Effects

Demand-Pull Inflation When aggregate demand (AD) in the economy is rising at a persistent rate that is not matched by the output of goods and services (AS), demand-pull inflation occurs. (AD is not matched by AS) AD > AS Why AD ? C, I G or (X-M) -expansionary monetary or fiscal policies -rise in consumption by households -rise in demand for countrys exports -rise in firms investment spending -Excessive speculative spending in GPL in NY
GPL P2 P1 AD1 Y2 Y1

Cost-Push Inflation Inflation that originates from supply side and is caused by rising production cost due to increasing factor prices. Mostly due to SRAS

Rise in cost of production -Wage-Push Inflation -Import-Price Push Inflation -Profit-Push Inflation -Tax-Push Inflation -Inflation due to exhaustion of natural resources

in GPL In NY
GPL P2 P1 AD AS2 AS1 Y1 Y2 Real NY

AD2 Real NY

Solutions

Demand side policies which focus on lowering AD to reduce GPL are used.

Supply side policies are aimed at reducing cost of production so as to increase AS to dampen the inflationary effect. Long term - Productive Capacity Short term - Costs of production

Copied from NYJC Econs Lecture Booklet and Mrs Chuas Notes

Fiscal Policy

Measures

Lowering Government Expenditure -On goods and services ( G) -On transfer payments ( C) Adjusting tax rates -Raising Income tax rates (Direct tax) Personal Income tax ( C) Corporate taxes on firms profits ( I) -Lowering indirect tax rates These cause AD to fall/shift left, GPL, reducing inflation.

(a) Reducing tariff (b) Reducing government fees and rentals (c) Government subsidies These lower production cost and hence raise AS.

Limitations

(a) Time Lags Decision lag (identified, studied), Execution Lag, Time lag before measures take effect. -Conditions may have worsened by then. -Or inflation may have been resolved, creating deflation instead

(b) Rigidity of government spending (c) Political Considerations ( in taxes is politically unpopular) Excha nge Rate Policy Measures

(b) Increased risk of a budget deficit -As fiscal policy production costs through govts revenue or G

To address inflation, a country can appreciate its currency, by buying its currency in the ER market (i.e. selling foreign currency), demand, ER of currency.

Price of domestic currency in foreign currency $F1 $F0 DD1 Q0 Q1

SS domestic currency

DD2 Qty of domestic currency

Causes exports in price, imports in price, Assuming PED of exports and imports >1, ER, (X M), AD, inflation

Currency, country can purchase imported raw materials at lower price, cost of production, price.

Copied from NYJC Econs Lecture Booklet and Mrs Chuas Notes

Limitations

(a) Availability of foreign exchange

(b) Effective only if PED of exports and imports >1

(b) Proportion of imported input. If product has proportion of imported input,

Effective (c) Loss in export and investment competitiveness ER price of exports Currency foreign investments

Incom es and price policy

Measures

(a) Voluntary and Statutory wage restraints on wage increases -Guidelines on permitted rates of wage rises -Restrict power of trade unions or persuade unions to practice a wage restraint policy

(b) employees CPF contribution rate

These disposable income, Thus AD

(b) Lowering wages

Employers CPF contribution rate, cost of production, thus AS (c) Controlling factor cost -Price ceiling usually on basic necessities and resources prevents prices from too quickly and profiteering. Supply of Factor price factor P0 Pc Demand of factor Factor Quantity

Limitations

(a) Problems with wage restraints -Need firms and trade unions to cooperate with the government -Demand-pull inflation tight labour market, wages to attract workers (b) Raising employees CPF contribution rate -employee can borrow instead -Inflation real income, this policy will real income more and standard of living (b) Price controls and black markets (c) Lowering wages - employees CPF contribution rate would contribution to employee CPF account, funds for housing loans, real income.

Monet Measures ary Policy Limitations

Contractionary monetary policy is used Money supply to interest rates,thus C & I (a) Effectiveness of MP tools
Monetary authority must be able to control the money supply. (b) Interest Elasticity of Investments and Consumption must n AD to be effective, Copied from NYJC Econs Lecture Booklet and Mrs Chuas Notes

Effective if investments are interest elastic (MEI curve gently sloped) (c) Other factors- Uneffective if (i) Economy is highly undeveloped (ii) Economy is open -Free flow of funds in and out of country, thus difficult for monetary authority to control money supply.

Copied from NYJC Econs Lecture Booklet and Mrs Chuas Notes