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Defining inflation
Inflation is a sustained increase in the average price level of a country. The rate of inflation is measured by the annual percentage change in the level of prices as measured by the consumer price index.
A sustained fall in the general price level is called deflation in this situation, the rate of inflation becomes negative.
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Causes of Inflation
Any inflation that results from an increase in demand is called demand-pull inflation Caused by
Increased Incomes Decreased income taxes Increased optimism about the future Decreased tendency to save
Causes of inflation
Any inflation that results from a
Caused by
Increased costs of raw materials
Increased Wages Failure to replace capital goods as they age, reducing its productivity, or increasing
Measuring Inflation
The CPI can be thought of as an imaginary basket of selected goods and services bought by a typical capital city household. The CPI is merely a measure of the changes in the price of this basket of goods and services. The price of the CPI basket in the base (first) period is given a value of 100 and the prices of subsequent periods are compared against the base year.
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Measuring Inflation
For example, if the price of the basket had increased 15% since the base year, the CPI would read 115, if the price had fallen by 15% since the base year the CPI would be 85.
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Measuring Inflation
The eight groups of the CPI are as follows:
Food Clothing Housing Education and Recreation
Transportation
Tobacco and Alcohol Health and Personal Care
Compilation of the CPI involves a quarterly survey of a basket of goods and services representing a high proportion of household expenditure.
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Causes of Inflation
Two Shifts
An increase in demand ( a shift in the demand curve to the right) A decrease in supply (a shift of the supply curve to the left) Price ($)
P1 Pe
Price
($)
S 1S
P1 Pe
D1
D
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Qe Q1 Q1 Qe
D Quantity
Quantity
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 SRAS becomes inelastic) The main causes of demand pull inflation
Very fast growth of demand for credit / borrowing
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AD
Y1
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SRAS
AD1 AD
Y1
Y2
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SRAS
In the SR the economy can work overtime, at a slightly higher cost (overtime)
AD1 AD
Y1
Y2
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SRAS
AD1 AD
In the LR, workers are not willing to sacrifice Leisure time for more overtime. But still have high wage expectations. demand pull inflation
Y1
Y2
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Causes:
External shocks (commodity price fluctuations) A depreciation in the exchange rate Acceleration in wages
SRAS1
Y2
Y1
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SRAS2
SRAS
Yfe
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P2 Pe SRAS2
SRAS AD1
Y2
Y1
Yfe
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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 this reduces economic growth and can lead to a recession
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