1. AS Macro Revision
Inflation and Deflation
Spring 2014

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3. Introduction to Inflation
Inflation is a sustained increase in the cost of living or the general
price level leading to a fall in the purchasing power of money
• The rate of inflation is measured by the annual
percentage change in consumer prices
• The UK government has set an inflation target of 2%
using the consumer prices index (CPI)
• It is the job of the Bank of England (BoE) to set policy
interest rates so that inflationary pressures are
controlled and the inflation target is reached
• A fall in inflation is not the same as a fall in prices! Only
when there is deflation will the general price level fall

4. Inflation Rate in the UK Economy in Recent Years
A lower inflation rate means
prices rise more slowly
Inflation in the UK has been persistently above
target for most of the last eight years

5. How is the Rate of Inflation Calculated?
• Inflation is measured by the consumer prices index (CPI) and the
retail price index (RPI)
• A base year is selected for price information and a family
expenditure survey is carried out
• A representative basket of goods and services used and weights
are attached to each item - based on items’ importance in
people’s expenditure
• Each month government officials collect 120,000 separate price
quotations in 141 locations of around 600 products
• Weights are multiplied by price changes - the weighted price
changes are then totalled to calculate the inflation rate
At the beginning of each year the weights used to compile both the
CPI updated using the latest information on household spending

6. The Weights in the Consumer Prices Index (2013)
Brought into CPI in 2013
• White rum
• Continental meats
• E-readers
• Daily disposable contact
lenses
• Hot chocolate
Taken out of CPI in 2013
The “shopping baskets‟ of items used in the
Consumer Prices Index (CPI) are reviewed
each year. Some items are taken out of the
baskets and some are brought in to make
sure the CPI is up to date and representative
of consumer spending patterns
• Champagne
• Gas barbeques
• Pairs of soft contact
lenses
• Round lettuces

7. Limitations of CPI as a Measure of Inflation
Not all households are average – the published figure for inflation is
rarely the actual rate of inflation experienced by different people
1. The CPI is not fully representative - it will be inaccurate for the
‘non-typical’ household, e.g. 14% of the CPI index is devoted to
motoring costs - inapplicable for non-car owners.
2. Spending patterns: e.g. Single people have different spending
patterns from households that have one or more children
3. Housing costs: The ‘housing’ category of the CPI measures
changes in the costs of rents, property and insurance, repairs. It
accounts for around 16% of the index. Housing costs vary greatly
from person to person e.g. Young people in rented property
4. Changing quality of goods and services: Although the price of a
good or service may rise, this may also be accompanied by an
improvement in quality as the product
5. New products: The CPI is quite slow to respond to the
emergence of many new products and services

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9. The Main Causes of Inflation
Demand Pull inflation
• Caused by excess aggregate demand
• Often linked to money and credit boom
• Economy close to full capacity (inelastic AS)
• Positive output gap (AD > potential GDP)
Inflation Expectations
Once inflation becomes
established in an
economy it can be
difficult to remove.
Cost Push Inflation
• Rising wage costs in labour market
• Increasing raw material and component
costs from domestic and overseas suppliers
• Rising import prices due to a falling
exchange rate – this increases import costs
Administered Prices
• Changes in regulated prices e.g. Water bills
• Changes in indirect taxes and subsidies
Most agents in the
economy
(workers, businesses, le
nders) will raise their
inflation expectations
and build it into their
calculations and
decisions

10. Cost-Push Inflation using AD-AS Diagram
Cost-push inflation occurs
when firms respond to rising
costs, by increasing prices to
protect their profit margins
Can be caused by:
1. Rising unit labour costs
2. Higher costs of
components / raw
materials
3. A depreciation in the
exchange rate causing a
rise in import costs
4. An increase in business
taxes e.g. VAT or
environmental taxes
GPL
AS2
AS1
GPL2
GPL1
AD
Y2 Y1 Real GDP

11. Demand Pull Inflation using AD-AS Diagram
GPL
AD1
AD2
AS
GPL2
GPL1
Y1
Y2 Real GDP
1. Demand-pull inflation
occurs when AD grows at
an unsustainable rate
leading a positive output
gap (i.e. Actual GDP >
Potential GDP)
2. When there is excess
demand, producers can
raise their prices and
thereby achieve bigger
profit margins
3. Demand-pull inflation is
most likely when there is
full employment of
resources, AS is inelastic

12. Analysis: Internal and External Causes of Inflation
Internal causes of inflation
External causes of inflation
A large surge in
property prices
Higher wages /
labour costs
Increase in world
oil / gas prices
Global inflation in
commodity prices
Boom in credit /
money supply
Rise in business
taxes e.g. VAT
A depreciation of
the exchange rate
High inflation in
other countries

13. We add new resources / links / articles every day
to our Economics blogs
Follow this link for the AS Macro Blog on Tutor2u
www.tutor2u.net/blog/index.php/economics/categories/C59

14. Analysis: Why is High Inflation an Economic Problem?
Many governments target a low but positive rate of inflation. They
believe persistently high inflation can have damaging consequences
• Inequality: Inflation has a regressive effect on lower-income families in
developed & developing countries – most of their wealth is held in cash
• Falling real incomes – if wage rises lag behind price increases each year
• Negative real interest rates: If the interest on savings is lower than inflation
• Cost of borrowing: High inflation may also lead to higher interest rates for
businesses and consumers with debts (e.g. Rising mortgage rates)
• Risks of wage inflation: This leads to rising labour costs and lower profits
• Business competitiveness: A high relative rate of inflation can reduce
competitiveness which will lower demand for the country’s exports
• Business uncertainty: High and volatile inflation is not good for confidence
partly because businesses cannot be sure of what their costs and prices are
likely to be. This uncertainty might lead to a fall in capital investment

15. Possible Winners and Losers from High Inflation
One of the effects of inflation is that it can lead to arbitrary changes
in the distribution of real incomes and wealth in a country
Winners
Losers
• Workers with strong wage
bargaining power
• Debtors if real interest
rates are negative
• Producers if prices rise
faster than costs
• Retired on fixed incomes
• Lenders if real interest
rates are negative
• Savers if real returns are
negative
• Workers in low paid jobs

16. Economic Recovery and Inflation in the UK
In recent years the rate of inflation has been higher than real GDP
growth – but inflation is now falling as the economy recovers
Some reasons for
falling inflation as
the UK economy
recovers:
1. Commodity
prices have
been
declining
2. Wages
continue to
grow slowly
3. Stronger
currency
4. Negative
output gap

17. Why is inflation difficult to forecast accurately?
Forecast inflation for UK (source: BoE)
Volatile
global energy
prices
Government
indirect taxes
can change
Volatile food
prices
Changes in
value of the
currency
Uncertain
growth of
aggregate
demand
The chart shows the UK CPI inflation
forecast published by the Bank of
England. The probability fan chart for
inflation indicates the range of
probabilities for inflation in the
forecast period.

18. Macroeconomic Policies to Control Inflation
Inflation can be reduced by policies that (i) slow down the growth
of AD or (ii) boost the rate of growth of aggregate supply (AS)
• Fiscal policy: A tightening fiscal policy would include less spending on
public and merit goods or welfare payments or raising direct taxes
• Monetary policy:
• A ‘tightening of monetary policy’ via higher interest rates or a
reversal of quantitative easing or tougher controls on bank lending
• Higher interest rates may cause the exchange rate to appreciate
bringing cheaper imported goods and services
• Supply side policies to increase productivity, competition and
innovation
• Direct controls
• Public sector pay controls e.g. Limiting pay rises for NHS workers
• Capping or other regulation of prices of utilities such as water bills

19. Price Deflation
Deflation is defined as a persistent fall in the general price level of
goods and services. The rate of inflation becomes negative.
GPL
AS1
AS2
GPL1
GPL2
AD1
AD2
Y2 Y1
Real GDP
Demand-side causes
• Deep fall in AD causing a
persistent recession
• Large negative output gap
– high spare capacity
Supply-side causes
•
•
•
•
Improved productivity
Technological advances
Significant fall in wages
High exchange rate

20. Possible Economic Consequences of Deflation
• Holding back on spending: Consumers may postpone demand if
they expect prices to fall in the future
• Debts increase: The real value of debt rises with deflation and
higher real debts can be a drag on consumer confidence
• The real cost of borrowing increases: Real interest rates will rise if
nominal rates of interest do not fall in line with prices.
• Lower profit margins: Lower prices can mean reduced revenues
and profits for businesses - this can lead to higher unemployment
as firms seek to reduce their costs by shedding labour.
• Confidence and saving: Falling asset prices such as price deflation
in the housing market hit personal sector wealth and confidence
• Income distribution: Deflation leads to a redistribution of income
from debtors to creditors

21. Economic Policies to Avoid Price Deflation
The main approach to avoiding deflation is to use stimulus policies
either by loosening monetary policy and/or fiscal policy
Low interest rates and quantitative easing
• Cheaper loans for businesses and households
• Expanding the supply of credit in banking system
Fiscal stimulus
• Higher government spending (e.g. Capital projects)
• A rise in government borrowing
Other measures to stimulate demand
• Attempts to lower the value of the exchange rate
• Higher taxes on savings to encourage consumption

22. Tackling Deflation – Abenomics in Japan
For many years the Japanese economy has struggled to break free
from a combination of weak growth and price deflation
Easing monetary policy
• Attempt to devalue Yen
• Higher inflation target (2%)
Fiscal stimulus
• Big rise in capital spending
The reflationary policies introduced
into the Japanese economy in recent
years have been given the name
Abenomics after the Prime Minister
who launched them. There are three
main “arrows of policy” designed to
boost demand, output, jobs and prices.
Structural reforms
• Designed to increase
competition and productivity

23. Get help on the AS
macroeconomics course
using twitter
#econ2
@tutor2u_econ
www.tutor2u.net