Inflation and deflation
Review questions
1) Define the term 'inflation'.
Inflation is an increase in the general price level and a fall in the purchasing value of money.
2) In which of the following situations is an economy suffering from disinflation?
a) The annual rate of inflation changes from 4% to 2.5%.
b) The annual rate of inflation has risen from 2% to 5%.
c) The annual rate of inflation is zero. d) The annual rate of inflation is constant at 2%.
=A
3) Explain why economists might be interested in the UK's core inflation rate.
The core inflation rate is the Consumer Price Index but excludes certain products whose prices are volatile. It is the CPI rate of inflation less prices that are subject to wide short-term fluctuations. For example food prices are volatile due to fluctuations in supply and the activities of speculators. This means that economists are able to use it as it shows the underlying rate of inflation, avoiding short- term fluctuations that may distort the CPI alternative.
4) In which of the following situations is an economy suffering from deflation?
a) The annual rate of inflation is falling from 4% to 2.5%.
b) The annual rate of inflation has risen from 2% to 5%.
c) The annual rate of inflation is zero. d) The annual rate of inflation is constant at -2%.
=D
5) Explain why governments try to avoid periods of deflation.
Aggregate demand in an economy that is suffering from deflation will fall as the burden of debts will increase. Extended periods of deflation mean that spending goes down, particularly for big ticket items, as consumers are willing to wait for a period of time as prices go down to get the best value for money. The consequence is an increase in savings, economic growth suffers as people spend less of their income on goods and services. This can often lead to job losses as firms get less revenue, reducing the aggregate demand of an economy. A decrease in spending can lead to a reduction in the amount of investment that firms are willing to make. This would have a negative multiplier effect on the GDP of an economy.
6) Which of the following is an example of demand-pull inflation?
a) A rise in consumer confidence and the level of consumption.
b) A rise in the price of wheat.
c) A rise in average real wages.
d) A rise in the rate of inflation major trading partner.
=A
7) Explain how a depreciation in the value of the pound might result in demand-pull inflation.
If the pound deprecates in value, the result would be an increase in the export components of aggregate demand, due to a fall in purchasing power of the pound. This will result in fewer purchases of imports therefore demand for local goods and services increases, which will cause an increase in aggregate demand, leading to inflation as more is demanded as the price is driven up. On the other hand, deprecation of the pound will lead to higher demand of exports as they become cheaper which again increases aggregate demand. These also therefore drives up inflation.
8) Explain the effects of a substantial fall in real wages, such as that experienced in the UK recently,on the rate of inflation.
Real wages are different to wages as they have accounted for inflation/deflation. If your wage decreases, it may be due to a deflation in the economy, so although your income has decreased, so has the prices of goods and services, therefore your purchasing power stays the same. However if your real wage decreases, as it is already adjusted for inflation/deflation you will suffer the consequences of inflation/deflation If real wages fall, people will begin spending less and purchasing fewer luxury or big ticket items, as consumers will wait for prices to fall. This will lead to a fall in aggregate demand and therefore decreasing inflation.
9) Explain why changes in the prices of commodities such as wheat and oil can have a significant impact on the rate of inflation in the UK.
Both wheat and oil are components of cost-push inflation, so are included in the calculation of the rate of inflation in the UK, and are also used in other products therefore can affect prices indirectly, such as the use of oil in transportation and used as a raw material in the production of products, including plastics. These goods that are components of CPI, are likely to have variable prices therefore when the goods' prices are high, there is an increase in the GPL (general price level) and therefore inflation occurs.
10) Explain the possible effects of the growth of emerging economies such as China and Brazil on the rate of inflation in the UK.
The UK has benefited in ways from the high rates of economic growth in emerging economies such as China and Brazil. Emerging markets mean that globalisation is able to become more open to international trade between economies. Rapid growth of the Chinese economy has contributed to falls in the real prices of many consumer products such as televisions, helping to keep inflation low. However, activities in emerging markets also have the potential to add to UK inflation. Rising demand for some globally traded commodities (for example, food) in huge economies such as Brazil and China can lead to price rises and supply of the products becomes relatively low. This has the potential to increase global prices and to impact on the rate of inflation in the UK.
