Economic impact of inflation and deflation

ECON605 - Managerial Economics

Amity Business School

Amity University, Uttar Pradesh

October, 2018
Inflation and deflation

 What is inflation?
Inflation: A
 A persistent increase in the level of persistent
prices
increase in the
 It is possible to have a declining rate level of prices
of inflation – there is still inflation but it
is growing less rapidly
 This is not deflation
Deflation: A
persistent fall in
 Deflation is a persistent fall in the
the price level
price level
Aggregate demand & Aggregate supply

 Aggregate demand (AD) or domestic final demand (DFD) is the

total demand for final goods and services in an economy at a given
time. It specifies the amounts of goods and services that will be
purchased at all possible price levels. This is the demand for the gross
domestic product of a country.

 Aggregate supply (AS), also known as total output, is the total supply
of goods and services produced within an economy at a given
overall price level in a given period. It is represented by the aggregate
supply curve, which describes the relationship between price levels and
the quantity of output that firms are willing to provide. Normally, there is a
positive relationship between aggregate supply and the price level.

 The aim of the tax changes is to stimulate the supply side of the
economy and therefore boost aggregate supply
Causes of inflation –
Demand Pull Inflation
 Demand pull inflation is when inflation is
caused by excess demand
 Anything that causes aggregate demand
(AD) to increase will cause demand pull
inflation
 What are the things that cause AD to
increase?
• Anything that causes any of the components
of AD to increase (C + I + G + (X-M)).
• GDP identified as “Y” in equation form,
include Consumption (C), Investment (I),
Government Spending (G) and Net Exports
(X – M).
• The affect will depend on where the
economy is in the cycle
• If an economy is in a negative output gap
there will be positive effects whereas if there
is a positive output gap an increase in AD
may fuel inflation
Causes of Inflation - Demand Pull
Inflation

 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 short
run aggregate supply SRAS becomes
inelastic)
 The main causes of demand pull inflation
 Very fast growth of demand for credit /
borrowing
 High levels of consumer spending
Main causes of demand pull
inflation

 A depreciation of the exchange rate increases

the price of imports
 it reduces the foreign price of exports
 A reduction in direct or indirect taxation
 consumers will have more disposable income
causing demand to rise Weak local
currency
 Rapid growth of the money supply imports dear
 consequence of increased bank and building society exports cheap!
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 Indian exports overseas (an
injection of AD)
Illustrating demand pull inflation

 At point A the economy is below full employment/capacity

 A shift in AD from to AD1 brings the economy close to
capacity
 There is an increase in price levels and the labour marketPrice Level
begins to tighten AD2

AD1 AS
 Any further increase in AD to AD2 causes demand pull
inflation C
B
 We get an increase in monetary GDP but not real GDP AD

 We can’t get any more output – the AS curve is perfectly A

inelastic
 The only reason that GDP is rising is due to prices rising
 Remember that GDP is the total value of goods and
services
RNO
 Monetary GDP is GDP that has not been adjusted for
RNO = Real National Output
inflation (for the rise in prices)
Causes of Inflation – cost
push inflation
 This is when increased costs of
production result in firms
increasing their prices
 This leads to an increase in the
general price level
 Causes – anything that causes firm’s
costs to rise:
 External shocks (commodity price
fluctuations)
 A depreciation in the exchange
rate leads to an increase in the
price of imported imports
 Acceleration in wages due to a
tight labour market where firms
have to increase wages to attract
the labour that they require
Causes of Inflation – cost push inflation

 The cost increases lead to inward shift in SRAS curve

 The short-run aggregate supply, or SRAS, curve is one of two curves
that graphical capture the supply-side of the aggregate market.
 Firms raise prices to protect their profit margins – better able to
do this when market demand is price inelastic
 Wages often follow prices
 A rise in inflation can lead to rising inflationary expectations
 While economists refer to these types of inflation separately they can
easily be linked
 Increased demand causing demand pull inflation can lead to
demands for higher wages which can lead to cost push inflation
Illustrating cost-push inflation

LRAS Cost-push inflation

Price Level is caused by an
inward shift of the
short run AS curve.
The more inelastic is
the demand curve,
the higher is the effect
on the general price
P2 level
Pe SRAS2
Cost push inflation
causes
SRAS unemployment
because less output
AD1
is produced

Y2 Y1 Yfe Real National

Output
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
 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 to lower capital
investment
Inflation can be a problem because it creates a range of economic and social costs. In assessing the
costs of inflation, we must distinguish between different degrees of inflation, since low stable inflation
has less of a damaging effect on the economy than hyperinflation where prices are out of control.
Costs and Consequences of Inflation

 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 which
reduces economic growth and can lead to a recession
 The overall effects of inflation on an economy depend on
 the rate
 whether it is fluctuating or stable
 whether the rate has been anticipated or not
 and its rate relative to that of other countries.

 High, unstable, accelerating and unanticipated inflation will involve

more costs than low, stable, declining and anticipated inflation
The overall effects of inflation on an economy depend on the rate, whether it is fluctuating or stable,
whether the rate has been anticipated or not and its rate relative to that of other countries. High,
unstable, accelerating and unanticipated inflation will involve more costs than low, stable, declining
and anticipated inflation
Full employment and the
measurement of unemployment

 Full employment = the full use of all labour

resources so that the economy can produce at
Price Level
the limits of its potential GDP or on the PPB AD2
 In reality 100% employment cannot be achieve as AD1 AS
there will always be unemployed people due to C
labour turnover, movement between jobs and B
AD
incapacity to work
 So if full employment is not full employment in the A
sense that everyone is employed how do we
define it?
 It is best explained as the situation that is occurring
when the AS curve becomes vertical
 The level of unemployment that represents full RNO
employment (where any increase in AD causes
inflation) is a bit of an unknown and may change
over time
Types/Causes of Unemployment

 Cyclical or Demand deficient

 This is unemployment caused by the cycles of the economy –
the booms and the slumps
 When the economy is booming there will be high demand for
products and services, production will be high, demand for labour
will be high and unemployment will be low
 When the economy is in a slump demand for goods and services
will be low, production will be low, demand for labour will be low
and unemployment will be high
 In the periods between the slumps and booms unemployment
will be decreasing
 In the periods between the boom and the slump
unemployment will be increasing
The business cycle and its affect on unemployment
In a boom
demand is high
As growth increases and
(recovery) demand unemployment is
increases and low
National output

unemployment
reduces

As growth decreases
demand reduces and
unemployment
increases
Recession or
slump – demand
is low and
unemployment
is high
O A B
Timefig
Types of Unemployment – supply-side causes

 Structural
 This happens when there is a fall in demand within a particular industry
• E.g. if there is a fall in demand for steel there will be a fall in demand for labour within the steel
industry and unemployment will increase within this industry
 Over the last couple of decades there has been structural unemployment in the India
primary and secondary sectors such as textiles, coal, shipbuilding and heavy
engineering
 Structural unemployment affects some areas worse than others (regional
unemployment) e.g. In England, South Wales has suffered due to the fall in demand for
coal, Scotland due to the fall in demand for ships, Lancashire due to the fall in demand
for British cotton textiles

Labour immobility
 Occupational immobility – workers cannot take up a job in another occupation
because they are not trained to do so e.g. a miner could not become an accountant
without training
 Geographic immobility – workers do not want to move to other areas where work
may be available because they do not want to move away from their family or the area
where the jobs are available is very expensive to live in.
Types of Unemployment
 Technological
 This is people that are put out of work by the introduction of new machinery
 Agriculture is one industry that has suffered from this type of unemployment
 When new machines were made available to plough, sow and harvest barley the hours of labour
required to grow barley on one hectare of land went down from 156 to12
 Seasonal
 Some people tend to work at some times of the year but not necessarily others
 E.g. agricultural workers may find more work in spring and summer than in the winter – an agricultural
worker that cannot find work in the winter is said to be seasonally unemployed.
 Frictional
 Temporary unemployment while people are out of a job and searching for another
 Some of this frictional unemployment may be seen as voluntary unemployment as some people
may deliberately leave jobs to look for a better one.
 Some may be involuntary when people are made redundant
 Both frictional and structural unemployment are always present as there are always people
between jobs and competition from abroad plus fast changing technology
 Firms relocating to cheaper areas of production and to escape high taxes are also likely to
create unemployment
The costs/consequences of unemployment

 Wasted resources
 Factors of production are lying idle
 The resources could be used to produce goods and services that would improve
our standard of living
 Unemployed people can become unemployable – why is this?
 When people have been out of work for a long time employers may be reluctant to
take them on
 People may forget their skills or their skills may become out dated
 People are less able to adjust to getting up in the morning and regularly go to work
 Some areas of the country become depressed – why is this?
 Young, skilled, mobile workers may move out of areas where unemployment is
high leaving the young, unemployed and old people who are low spenders

 Demand for goods and services drops further causing firms to close down and
move away from the area
Costs/consequences of unemployment

 Social problems – why?

 Creates strains on family life

 Men lose their status and feel they are letting their family down

 Fall in living standards

 Marital break down

 Physical and mental illness

 Suicide

 Expensive for the economy – why is this?

 Government pays out enormous sums of money in benefits and this increases as
unemployment increases

 Less people will be paying taxes giving less money to spend

 Working people have to pay taxes to support the unemployed

Policies to reduce unemployment

 Economists and politicians argue about the best way to reduce

unemployment. Here are some of the ways that have been suggested or
used
 Policies to increase spending
 Increasing demand increases production which increases demand for labour
 How can government increase spending?
• Tax cuts will give people disposable income
• Interest rate cuts will do the same (they will be paying less on their mortgages which
will give them more to spend) and will encourage investment
• They could spend more themselves by borrowing – this will lead to more jobs and
more money to spend

 De-industrialisation has decreased exports and caused unemployment

however if the country cannot be competitive there is little point in
investing in the manufacturing sector.
Policies to reduce unemployment

 Policies to control inflation

 Why would stopping prices rising reduce unemployment?
 In the late 1970’s the UK government thought they could reduce unemployment by
controlling inflation
 If prices are high then firms will invest less leading to unemployment
 The problem with this is that the ways in which government controls inflation by
spending less and by cutting the money supply causes unemployment (initially)
 Cutting unemployment benefit
 Why would this reduce unemployment?
 Some politicians and economists believe that if too much unemployment benefit is
paid then the unemployed person does not have an incentive to go back to work
 They believe that if the benefits are low the unemployed will take low paid jobs
rather than be unemployed.
 If people would accept lower wages then more jobs would be created to employ
them
Policies to reduce unemployment

 Policies to control imports

 Why would reducing imports reduce unemployment?
 Some believe that if cheap goods are not imported they will have to be made in
country by British manufacturers and this will create more jobs
 Flexible working policies (different ways of working) e.g. part time, job
sharing etc
 Why would this reduce unemployment?
 If firms employ people of a part time basis they will employ more
 For example if a position is shared by 2 people doing 2.5 days each there will be 2
people employed rather than 1
 What type of unemployment does this help?
 Seasonal unemployment
 Regional policies – encouraging firms to set up in certain regions
 What type of unemployment does this help?
 Structural unemployment / regional unemployment
 This will increase employment in those regions
Policies to reduce unemployment

 Policies to increase labour mobility

 Why would increasing labour mobility reduce unemployment?
•This would help people to move to jobs that are available in different areas or different
occupations

 What kinds of things can government do to increase mobility?

• Training schemes – to help people to learn new skills and move to new occupations
• Stopping discrimination so that companies have to employ any person regardless of
their race, gender, or age
• Making job opportunities known through job centres
• Helping people start up their own businesses e.g. princes trust that helps unemployed
young people start their own businesses.
• Affordable housing in all areas will help to move to a new area.
Evaluation of supply-side policies

 In evaluation of supply-side causes consider government response to

structural unemployment in terms of retraining schemes
 Some may be too old to retrain
 Also jobs need to be available in the areas that they are retraining
 There needs to be sufficient aggregate demand for the economy to employ
them
 As they are starting at the bottom they will need to accept substantial
wage reductions
 They may feel that they are better off on benefits
 We need to question whether government is best placed to judge the
needs of the private sector or could this result in government failure?
Unemployment and output gaps

 When there is a positive output gap we would expect unemployment to be low

 The labour market will be tight
 Cyclical unemployment is falling
 Due to supply side causes of unemployment there are still likely to be people unemployed –
they don’t have the skills or are still searching for a better level of wages
 Those searching will remain unemployed longer if levels of benefit are high relative to wages

 A lower level of benefits might persuade the frictionally unemployed to return to work more
rapidly and reduce some of the tightness in the labour market

 The quicker the unemployed can be retrained and returned to the labour market the greater
the benefit for the economy
 During a negative output gap there will be both demand deficient unemployment and structural
unemployment
 Some labour may become discouraged workers thinking they will never find a job – they may
permanently withdraw from the labour market