Low & Stable Rate of Inflation

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Economic Growth

Low Unemployment

Low Inflation

(HL) Sustainable Level of Debt

Conflicts Between Objectives

This is a long page. I tried to condense it but there is a lot to know. All of this is on the syllabus.

Inflation

Inflation is the sustained rise in the general price level in an economy over time. Price stability refers to the general price level remains constant as a result of low and stable inflation.

Measuring Inflation using CPI

Inflation can be measured using the Consumer Price Index (CPI). CPI is measured with:

A base year. At the base year, the price index of goods and services are equal to 100. Changes in this price index can be measured by comparing to the base year. If the CPI is 110 the next year, there has been a 10% inflation in that year.
Measuring the change in CPI is done by collecting information of prices of a typical household's expenditures. This typically includes food, gas, and transport.

You will likely be asked to calculate inflation of a given year. Just remember that:

Percentage change = [(New-Old)/Old] x 100

However, goods and services usually have different weights, as some things are purchased more by households than others.
In that case, simply multiply the price index of the category by the weight ->

Limitations of Measuring Inflation using CPI

Not all households have the same expenditures, and CPI only accounts for an average household.
Inflation can vary within regions of a country, and CPI only accounts for the general price level.
CPI does not measure changes in product quality. Something might become more expensive, but also have better features (Nokia phones -> Smartphones)
Consumption patterns change over time, so the "basket" that CPI uses will have to change.

Causes of Inflation

Demand-Pull Inflation: ->

Inflation is caused by higher demand for goods and services in the economy, which grows faster than the supply.
Considered the "good" inflation, because while the general price level rises, real GDP does so, too.

Cost-Push Inflation:

Inflation is caused by higher costs of production, shifting AS to the left.
Considered the "bad" inflation, because prices rise and real GDP shrinks.

Demand-Pull Inflation

Cost-Push Inflation

Costs of High Inflation

A little inflation is good, but too high inflation results in:

Uncertainty - Lower confidence in the economy, leading to less Consumption and Investment
Redistributive effects and effects on savings - Worse for poor people who were already struggling. Savers will lose out as their savings are worth less, borrowers will gain as the money they have to pay back to lenders is now worth less (and easier to obtain), and lenders will lose as the money they get from borrowers is now worth less. See "calculating real interest rate" for more
Damage to export competitiveness - Exporting goods and services becomes more expensive and imports become cheaper, so Net Exports decreases
Impact on economic growth - Workers are likely to want raises, raising costs of production, decreasing AS
Inefficient resource allocation - Having to update prices and look for cheaper alternatives of goods and services takes time, leading to inefficiencies.

Deflation

Deflation is the sustained fall in the general price level in an economy over time (the exact opposite of inflation).
Benign deflation occurs when AS shifts to the right. This is good because prices go down and real GDP increases.
Malign deflation occurs when AD shifts to the left. This is bad because while prices go down, so does real GDP.

Malign Deflation (Bad)

Benign Deflation (Good)

Deflation vs Disinflation

Deflation refers to the sustained fall in the general price level over time.
Disinflation means a decrease in the rate of inflation. If the inflation rate was 10% and is now 5%, the economy has experienced disinflation.

Costs of Deflation

Uncertainty - Confidence levels decrease, reducing the levels of Consumption and Investment in the economy
Redistributive effects - Savers will win as their savings are worth more, borrowers will lose as the money they have to pay back to lenders is now worth more (and harder to obtain), and lenders will win as the money they get from borrowers is now worth more. See "calculating real interest rate" for more
Deferred consumption - If things cost less, people are going to wait before they buy, as they expect prices to continue to decline. This results in even less consumption, causing a deflationary spiral
Association with high levels of cyclical unemployment and bankruptcies - If malign deflation (the bad kind) happens, less employment is needed, and firms will go bankrupt as fewer buy their goods and services.
Increase in the real value of debt - As prices go down, money is worth more, making debt technically worth more than before. See "calculating real interest rate" for more.
Inefficient resource allocation - Scaling back employment leads to inefficiencies.
Policy ineffectiveness - Economic policies are less effective in deflationary times, as interest rates can only go so low, and the government becomes reluctant to gain debt.

What's worse - Unemployment or Inflation?

Both are macroeconomic objectives, but which one should be a higher priority for governments? Well, priorities change over time, but it is unclear. It depends. Yes, that's what the syllabus says. It's a good topic for an IA or paper 1 evaluation...

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