Answering Inflation and Deflation Review Questions (Revision)

Define the term 'inflation'.
Inflation is the rate of increase of the general price level  for goods and services and the corresponding fall in the value of money.


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 changed from -2% to 1%.
C) The annual rate of inflation is zero.
D) The annual rate of inflation is constant at 2%.

Explain why economists might be interested in the UK's core inflation rate.
The core inflation rate is based on the CPI but excludes certain products whose prices are volatile, for example food or oil prices. It is used to measure the underlying rate of inflation which gives economists more of an idea on how CPI will change in the near future.


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%.


Explain why governments try to avoid periods of deflation.
Deflation is the rate of decrease of the general price level and the corresponding rise in the value of money. Falling prices encourages firms and consumers to stop spending and save as they wait for prices to fall further. This will cause a sudden fall in consumption and hence aggregate demand. Firms will reduce production and so will require less labour, causing an increase in unemployment. The result can be a large reduction in GDP.
The increase in the value of money will also increase debts, such as mortgages and loans and so households and firms will be less willing to spend. Interest rates will increase so firms and households will be very reluctant to borrow money for consumption or investment. Government debts will also increase, likely leading to a reduction in public expenditure. Aggregate demand and hence GDP will decrease.

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 in a major trading partner

Explain how a depreciation in the value of the pound might result in demand-pull inflation.
Demand pull inflation is a rise in the general price level that results from an increase in aggregate demand. A depreciation in the value of the pound means that more pounds are needed to buy a unit of another currency. This means that the price of UK exports overseas decreases and the price of imports into the UK increases. Therefore demand for exports will rise and demand for imports will fall. Because of this, the total value of exports will increase and the total value of imports will decrease. AD = C + I + G + ( X - M ) and ( X - M) has increased so aggregate demand will increase.

Explain the effects of a sustained fall in real wages, such as that experienced in the UK recently, on the rate of inflation. 
Real wages is the factor payment received by households from firms in return for labour, and adjusted to inflation. A sustained fall in real wages means that the cost of labour input per unit of output will decrease. This means that the firms can set a lower price for goods and services whilst still receiving the same profit because the overall cost of production has decreased. There is a reduction in inflationary pressure and because the firms can afford to lower the general price level or to increase it at a decreasing rate, deflation or disinflation may occur.

Explain why changes in the price of commodities such as wheat and oil can have a significant impact on the rate of inflation in the UK.
Wheat and oil are largely imported into the UK and so changes in their price in other global markets can have a significant effect on their cost of production which can have a large effect on inflation in the UK because when their price increases, firms are forced to raise the price of goods and services if they want to keep making the same profit (cost-push inflation). This is especially the case for oil and wheat because they are part of the 'basket' of goods and services that is used to calculate CPI and also because they are used to produce other products. For example, oil is used to produce fuel for transporting goods and services as well as making plastics. Therefore it will also have an indirect effect on the cost of production, which can further increase inflation.

Explain the possible effects of the growth of emerging economies such as China and Brazil on the rate of inflation in the UK.
An emerging economy has a low income per capita but is enjoying high rates of economic growth. China's economy has grown strongly due to a large supply of low-cost labour to manufacture goods cheaply. The real prices of many consumer products have fallen due to the need of UK firms to stay competitive with the cheap products from China and so this has helped lower inflation.
However these emerging economies can also add to inflation in the UK. Rising demand for globally traded products caused by these emerging economies can lead to an increase in price as the supply of these resources becomes lower. This is demand-pull inflation. The UK will be affected when importing these products and the cost of production for firms using these imported products will increase. This is cost-push inflation.

Understanding the circular flow of income and the multiplier effect (Revision)

Y(national income) = E(expenditure)
                                = C(consumption expenditure) + I(investment expenditure)

In the diagram, National Income is branch 4 and Consumption Expenditure is branch 1.

Investment Expenditure is defined as: Spending by firms on capital (a factor of production), for example buildings, equipment or machinery.
So Investment Expenditure would also be on branch 1.

Therefore I thought that Y = I, but I also knew that Y = C because in this simplified model, all of the money that the households receive as income will be spent on goods and services produced by firms.

So Y = I is incorrect.

And if Y = C + I, and Y = C also, then I = 0.

So Y = C, only when the firms do not spend any money on capital.

If the firms do choose to invest money in capital, then National Income will increase (as Y = C + I).

Therefore Consumption Expenditure will then increase (as Y = C).

This means that the firms will have more money so they can buy even more capital goods.

This has the same effect again with National income increasing and so then consumption expenditure increasing.

I have stumbled upon the multiplier effect, except with all withdrawals ignored (savings) in this simple case, the multiplier would be infinite and National Income would continue to increase indefinitely.