Inflation and Deflation

Inflation - a rise in the rate of change of the general price level over a certain time period

Disinflation - the general price level rising but at a slower rate. It is still above zero.

Deflation - a fall in the rate of change of the general price level (below 0)

Benign deflation  - deflation is not necessarily bad. If falling prices are caused by higher productivity, as happened in the late 19th century, then it could go hand in hand with robust growth.

Malign deflation - occurs when prices are falling because of a structural lack of demand which creates huge excess capacity in an economic system. It cannot be easily changed.

If there is a slump in demand, companies go out of business and start to make employees redundant, and hence demand falls again - the negative multiplier.

Demand Pull:

• lower interest rates 
• rising house prices 
• rising real wages
• devaluation of the exchange rate 

Cost Push:

• higher prices of commodities
• imported inflation 
• higher wages 
• higher taxes 
• profit push inflation
• higher food prices 

The Quantity Theory of Money 

Developed by Irving Fisher to explain the link between money and the general level of prices. Fisher was a monetarist who believed that inflation was always caused by changes in the money supply.

V velocity of the circulation of money

M money 

Q/Y quantity of goods and services (Real GDP)

P average price level 

MV = PQ                   P=MV/Q

Monetarists say that V and Q are fixed historically (they don't change enough to influence prices)

Keynesians suggest that Q and V are not fixed eg in a recession like the liquidity trap ^M and decreased V. They argue that M directly affects P.

A closed currency is one that is not available for purchase in countries other than its country of origin. There are both import and export restrictions, and tourists cannot take currency into or out of the country.

Inflationary Expectations The extent of the consequences of inflation can be impacted by the extent to which inflation has been anticipated. 

If inflation has been stable at 2% for…