logging in or signing up Low and stable inflation juliapeters Download Post to : URL : Related Presentations : Share Add to Flag Embed Email Send to Blogs and Networks Add to Channel Uploaded from authorPOINT lite Insert YouTube videos in PowerPont slides with aS Desktop Copy embed code: Embed: Flash iPad Dynamic Copy Does not support media & animations Automatically changes to Flash or non-Flash embed WordPress Embed Customize Embed URL: Copy Thumbnail: Copy The presentation is successfully added In Your Favorites. Views: 246 Category: Education License: All Rights Reserved Like it (0) Dislike it (0) Added: May 14, 2012 This Presentation is Public Favorites: 0 Presentation Description Teacher presentation IB Comments Posting comment... Premium member Presentation Transcript Low and Stable rate of inflation IB Economics: Low and Stable rate of inflation IB EconomicsPowerPoint Presentation: Inflation Inflation is what? A persistent rise in average prices in the economy (learn this!!) How is it measured? Normally using the CPI – Consumer Price Index What is the inflation target? Depends on the country The UK is 2% CPI Watch inflation video Show how prices have changed over the years Inflation – a persistent increase in the average price level in the economy usually measured with the CPI (Consumer Price Index)PowerPoint Presentation: Why worry about inflation? There are a significant number of negative consequences associated with high levels of inflation Loss of purchasing power If the rate of inflation is 2% the average price of all goods and services in the economy has risen by 2% If your salary/wages stays the same then it means you can buy less goods and services Your purchasing power (the amount you can buy) has been reduced In this case we say that you have had a fall in real income (income adjusted for inflation)PowerPoint Presentation: Why worry about inflation? Loss of purchasing power If your income was linked to the inflation rate you would automatically get a 2% cost of living increase which means your real income has remained the same If you worked for a company that had a strong union this may be the case but lots of people do not have inflation linked incomes Self employed, weak trade unions, fixed incomes (old people on pensions/unemployed on benefits) Expected rates of inflation are important If your company expects 1.5% inflation and gives you an increase of 1.5% but then the inflation rate turns out to be 2% your purchasing power will have reducedPowerPoint Presentation: Why worry about inflation? Effect on saving If you save $1000 in the bank at 4% annual interest you will end up with $1,040 If the inflation rate is 6% then the real rate of interest (the interest rate adjusted for inflation) will be negative (4% - 6% = -2%) Your savings will not buy as much as they did the year before You would have been better to spend it than save it You will have lost purchasing power Inflation therefore discourages saving People will buy assets such as houses or art which will be worth more As the bank uses savings to lend to others – less saving will mean less funds for investment This may have negative implications for growthPowerPoint Presentation: Why worry about inflation? Effect on Interest Rates Commercial banks make money from charging interest to people who borrow money If there is a high rate of inflation banks will raise their interest rates to keep the real rate that they earn positive Effect on international competitiveness If a country has a higher rate of inflation than its trading partners its exports will be less competitive Imports from lower-inflation countries will be more attractive This may worsen the balance of payments This could lead to unemployment in export industries and industries that compete with importsPowerPoint Presentation: Deflation There is good deflation and bad deflation Good deflation This comes about from the LRAS shifting Output will increase and price levels with fall This assumes that AD remains (ceteris paribus) This will also give a lower level of unemployment (derived demand for labour from the increased demand for goods and services Deflation – a persistent fall in the average price level in the economy usually measured with the CPI (Consumer Price Index)PowerPoint Presentation: Deflation Bad deflation This comes about from AD shifting A downwards shift of AD will result in lower price levels but also lower output (less growth) This could lead to an increase in unemployment Demand for goods and services will decrease Labour is a derived demand If people think prices will go down they will put off consumption When they see prices fall this will confirm their thoughts They will further put off consumption and AD will keep fallingPowerPoint Presentation: Deflation Japan has a problem with deflation Banks collapsed due to bad debts and bad investments in their own stock market People built up precautionary savings in case they lost their jobs This depressed consumption and AD Interest rates were cut to 0.25% but it didn’t work The damage had been done Consumer and business confidence crumbled with people and firms reluctant to spend Don’t confuse deflation with a falling rate of inflation (this is called disinflation)PowerPoint Presentation: Deflation/Disinflation From 1999 to 2000 the inflation rate rose from 1.2% to 1.6% From 2000 to 2001 the inflation rate fell from 1.6% to 1.3% the average level of prices rose but at a lower rate than the previous year – disinflation In the next two years the inflation rate continued to fall (prices were still rising but by a smaller and smaller amount) In 2004 the country started to experience deflation (the average level of prices fell by 0.5%) From 2004 to 2005 the country was still in a period of deflation where average prices fell by 0.3%PowerPoint Presentation: Do you understand? Which period of time did Japan experience Inflation Disinflation deflationPowerPoint Presentation: Costs of Deflation Although consumers may be pleased with falling prices there are many problems with deflation Deflation is also a bit of an unknown so it is more difficult to deal with than inflation Some economists argue that the costs of deflation are higher than inflation Unemployment If AD is low businesses may lay off workers If prices fall consumers will put off purchasing Firms will have to drop prices to encourage consumption Consumers will again put of purchasing believing that prices will fall further (deferred consumption) Consumer confidence drops further depressing AD This is known as a deflationary spiral Investment will also be put offPowerPoint Presentation: Costs of Deflation Costs to debtors Anyone who has taken a loan (including house buyers who have taken a mortgage) suffers from deflation because the value of their debt rises If profits are low businesses will find it difficult to pay back loans There may be many bankruptcies This will make business confidence even worse Play Japan Inflation videoPowerPoint Presentation: Measuring Inflation - The Consumer Price Index (CPI) The CPI is a weighted price index used to measure the change in the prices of a typical basket of goods and services The contents of the basket are changed each year In the UK they use information from the Family expenditure Survey Changes in weighting reflects changes in spending behaviour (the more that is spent the higher the weighting) In 2008 fruit smoothies, muffins and USBs were included in the basket Microwaves, 35mm camera film and CD singles were removed Family Expenditure Survey : a representative monthly survey of UK household expenditure used to derive changes in the CPIPowerPoint Presentation: Limitations of the consumer price index as a measure of inflation Different population groups experience different rates of inflation The CPI is an average household and not representative of individual households The weighting for tobacco or motoring expenses will be irrelevant for non smokers and those without a car The CPI does not include house prices Mortgage prices will be a high proportion of spend of younger house buyers Many older home owners will have paid off their mortgages The CPI may overestimate inflation Price rises may hide improvements in the quality of goods and services Cars and electrical goods may have gone up in price but this is due to new innovationsPowerPoint Presentation: Causes of inflation Inflation comes from several sources It can come directly from the domestic economy Price strategies of leading food retailers based on the strength of demand or competitive pressures A rise in VAT cause firm’s production costs to go up and these being passed onto the consumer It can come from external sources Increase in price of crude oil or other imported commodities, foodstuffs and beverages Changes in exchange rates A falling pound against the Euro might cause higher import prices (remember WIDEC?)PowerPoint Presentation: Causes of inflation There are 3 main types of inflation that are caused by different things Demand pull inflation Cost push inflation Excess monetary growth As the name suggests demand pull inflation is caused by an increase demand (AD) Most likely to occur when there is little spare capacity in the economy Increase in AD will lead to an increase in prices When does AD increase? When one or more of the components increases Draw a diagram illustrating demand pullPowerPoint Presentation: Causes of inflation Cost push inflation occurs as a result of an increase in the costs of production Any increase in a firm’s costs pushes the supply curve up If the cost of an input such as oil that affects the costs of all business in the economy increases the SRAS will shift upwards Things that cause production costs to go up and force firms to raise their prices to maintain profit margins A rise in costs of imported raw materials (e.g. by a fall in the value of the country’s currency) Rising labour costs Higher indirect taxes Wage price spiralsPowerPoint Presentation: Causes of inflation Cost push and demand pull together Let’s say house prices rise and the wealth effect comes into play The economy has little spare capacity (it is working close to full employment) Consumption increases aggregate demand increases capacity causing demand pull inflation (1) workers will demand higher wages to help them keep their current standard of living This demand for higher wages will cause cost push inflation (2) Higher wages may also give households the illusion that they have more money This will further increase consumption and increase AD (3)PowerPoint Presentation: Causes of inflation Excess monetary growth Monetarists (a branch of new classical economists) believe that inflation is caused by excessive increases in money supply If there is more money in the economy there will be higher spending AD will increase Because this is a new classical theory we draw the LRAS vertical Increasing money supply (quantitative easing) tends to be a policy of last resort In the UK the Bank of England has recently (2012) decided on a policy of QE because the low interest rates were not encouraging consumption They believe it is safe to do this because there is spare capacity in the economy but are watching the outcome carefully Milton Friedman (1912-2006) was a Monetarist who passionately believed that government intervention always causes more harm than goodPowerPoint Presentation: Reducing inflation The appropriate policy depends on the cause of inflation If the cause is the price of oil then this is an external factor which is out of government’s control If it is demand pull inflation government can try to dampen demand using deflationary/contractionary fiscal or monetary policy Evaluation There are often problems with contractionary policies Increasing taxes, reducing government spending or putting up interest rates are not popular measures There are lags with both fiscal and monetary policy of 1 to 2 years Government spending budgets are developed over a long period of time and may need lengthy legislative procedures to make any changesPowerPoint Presentation: Reducing inflation / Evaluation Monetary policy will harm some people in the economy more than others Anyone that has a loan or mortgage and businesses that want to invest Any government that is looking to be re-elected will be reluctant to use these measures This is one of the reasons that many developed countries have monetary policy managed by their central bank which is an independent body The UK MPC need to make sure that inflation is kept within +/- 1% of 2.5% otherwise they have to write a letter to the government explaining why The Fed does not have an official target It is important that people have faith in the central bank to keep inflation rates stable or they will demand higher wagesPowerPoint Presentation: Reducing inflation / Evaluation Nowadays monetary policy is considered to be the most effective way of managing AD in the economy Interest rates are seen as the best weapon Fiscal policy is not seen as an effective tool for inflation Governments have commitments to the public so it is very difficult to cut spending Plus any cut in G would take a long time to have an effect on price levels. Supply side policies are used to fix cost push inflation (as long as it is a domestic issue) It is really difficult to say which bit of inflation is cost push and which bit is demand pull so policy makers tend to use a mix of solutionsPowerPoint Presentation: Reducing inflation / Evaluation The biggest issue with reducing AD is the loss of output and hence unemployment Potentially there is a trade off between inflation and unemployment If unemployment is lowered AD will increase causing inflation If inflation is lowered AD will decrease causing unemployment Responsibility for managing AD might be best left to automatic stabilizers of fiscal policy and careful changes in monetary policy carried out by and independent central bankHL only Calculating Inflation: HL only Calculating InflationPowerPoint Presentation: Using index numbers This is straight forward if you can calculate percentage changes This table shows the made up index of house prices 2005 is the base year In 2006 there is an increase of 8.4% so the index goes up to 108.4 In 2007 there is an increase of 20% since 2005 so the index is 120.0 We need to take more care when working out the percentage change from 2006 to 2007 It is not 11.6% It is (120-108.4)/108.4 x 100 = 10.7% (Difference between the two years divided by the original year) Year Index 2005 100.0 2006 108.4 2007 120.0PowerPoint Presentation: Using index numbers When we bring several indices together in a basket we have to give each one a weighting The weighting will depend on the proportion of income that is spent on that good If we take this example on average 40% of income is spent on housing so it gets a weighting of 0.4 To work out the weighted index you just multiply the index by the weight Category Index for year X Weight Index for year X times weight Index for year X +1 Weight Index for year (X+1) times weight Housing 120 0.4 48 130 0.4 52 Foodstuffs 105 0.2 11 105 0.2 11 Travel 120 0.2 24 125 0.2 25 Clothing 120 0.1 12 110 0.1 11 Entertainment 125 0.1 12.5 130 0.1 13 Totals 107.5 1 112PowerPoint Presentation: Using index numbers To find out the rate of inflation you need to do the following sum New index – old index divided by old index In this case it would be Index for (X +1) minus Index for X divided by Index for X Multiply by 100 to get the % inflation rate (112 – 107.5) / 107.5 = 4.2% Category Index for year X Weight Index for year X times weight Index for year X +1 Weight Index for year (X+1) times weight Housing 120 0.4 48 130 0.4 52 Foodstuffs 105 0.2 11 105 0.2 11 Travel 120 0.2 24 125 0.2 25 Clothing 120 0.1 12 110 0.1 11 Entertainment 125 0.1 12.5 130 0.1 13 Totals 107.5 1 112PowerPoint Presentation: Time for you to do some work!! For homework do some research on inflation in your chosen country SL – P241 1a & b HL – P242/3 Data Response Perfect 10! Definition Diagram Analysis Example Perfect 15! New Definition More developed diagram/s Argument for and against with evidence Judgement You do not have the permission to view this presentation. In order to view it, please contact the author of the presentation.