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Inflation and Deflation

Inflation and Deflation

Have you noticed that the prices of products and services are gradually increasing? What product that you could buy for £1 last year costs more this year? This situation is very common, and in economics, it’s called inflation. On the other hand, if prices of goods are decreasing this is called deflation. Let’s talk about inflation and deflation and why they’re so important in economics.

Inflation

Simply put, inflation is the progressive increase in the prices of goods and services in an economy.

Inflation is a general rise in the price level in the economy.

These goods and services include:

  • Essential goods (such as food items, hygiene products, housing supplies, clothing, etc.).
  • Housing and cars.
  • Rental services (car, accommodation, etc.).
  • Luxury goods.

These are only a few examples, there are a lot more. Try to think about the items you consume daily and occasionally and they should probably be on this list.

There are two types of inflation:

  • Demand-pull inflation: this is when inflation is caused by excessive aggregate demand. This means that the aggregate demand is rapidly increasing, faster than the long-run aggregate supply of the economy, creating inflation.

  • Cost-push inflation: this is when inflation arises due to issues in the supply-side of the economy. It can occur due to the increased union power in the wage bargaining process, or through an increase in either commodity or energy prices. This usually causes the short-run aggregate supply to shift to the left due to increased costs of production, creating inflation.

How to calculate inflation?

There are two methods that the government uses to calculate inflation. These are the Retail price index (RPI) and the Consumer price index (CPI).

The RPI inflation was used for a number of years in the UK until 2003, but it is not currently used. The main purpose of using RPI was to calculate the inflation in the retail prices by including mortgage interest repayments.

Currently, the government uses the CPI, which is relatively similar to the RPI but doesn’t include mortgage interest repayments. The key features of CPI are:

  • The government records the expenditures of the ‘national shopping basket’. This usually consists of goods that people consume on a daily basis.

  • The CPI is calculated based on data collected from various supermarkets. The data includes family shopping basket prices.

  • To calculate the index, items that are included in the shopping basket are weighted in regards to their importance. The importance is decided depending on how much the household spends on the item: the more they spend on it, the higher the importance and thus the weight of the item.

  • The CPI can be used to calculate the prices of the shopping baskets of various consumer groups and consumers in different geographical regions. It can also identify the periods of inflation and deflation.

  • The CPI results can be compared annually to calculate the inflation rate throughout the years in regards to consumers' shopping baskets.

If a household spends £400 a month on food and drink and £100 on footwear, food, and drink will have a higher weight in the shopping basket.

CPI example

The table below represents an example of CPI calculation. The items in the example are the essential items consumed by the household. The importance or weighting of each product or service displayed in the example depends on how much the household spends on it. The weighting of all items should usually add up to 1000. The price index of the previous year (2020) is always displayed as 100 and the increase in price is shown in the ‘Price index in 2021’ column.

ItemWeightingPrice index in 2020Price index in 20212021 Price index X weighting
Food and drinks50010010653,000
Transport20010010320,600
Clothing and footwear30010010932,700
Total1000--106,300
1. To calculate the CPI in this example, we need to first, multiply the ‘weighting’ column by the ‘Price index in 2021’ column of each item individually. 2. We then need to add the calculated sum of the ‘price index X weighting’ of each item together. In this example, the sum of all price ‘indexes X weighting’ is 106,300 (see the last column). 3. Next, we need to divide this number by 1000. Here 106,300 / 1000 = 106.3. This gives us the price index of 106.3 in 2021 regarding all items. 4. Finally, to calculate the inflation rate, we need to subtract 100 (which is the previous year’s index) from 106.3. This gives us an inflation rate of 6.3% from 2020 to 2021.

Deflation

Deflation is the opposite of inflation. It means that the prices of goods and services in an economy are falling.

Deflation is a general fall in the price level in the economy.

Deflation usually occurs due to the following reasons: there may be a fall in aggregate demand, which would cause the general price level to decrease. Alternatively, the short-run aggregate supply could shift to the right due to decreased costs of production, causing the general price levels in the economy to fall.

What are the causes of inflation and deflation?

Inflation and deflation usually do not occur naturally. There are different factors that cause them.

The causes of inflation

The two main types of inflation (demand-pull and cost-push) are caused by different factors that affect the economy.

Demand-pull inflation

  • The main cause of demand-pull inflation is an increase in aggregate demand. The prices of products and services will increase to stimulate firms to produce more output in response to growing demand.

  • The positive output gap is another cause of demand-pull inflation. It means that the growth rate of the economy is above the trend growth rate, which leads to higher inflation.

The trend growth rate of the economy is the long-term rate of economic growth which is sustainable in a way that it will keep inflation to a minimum

Inflation and Deflation Demand pull inflation StudySmarter OriginalsFigure 2. Demand-pull inflation, StudySmarter Originals

Figure 2 depicts demand-pull inflation. The aggregate demand for goods and services increases from AD1 to AD2 (a rightward shift), causing an increase in the price level from P1 to P2.

Cost-push inflation

  • Additionally, cost-push inflation can be caused by the increased commodity or energy prices, which raises the overall cost of production causing the short-run aggregate supply to shift to the left.

Inflation and Deflation Cost push Inflation StudySmarter OriginalsFigure 3. Cost-push Inflation, StudySmarter Originals

Figure 3 depicts cost-push inflation. The short-run aggregate supply curve shifts to the left from SRAS1 to SRAS2 due to increased production costs, causing an increase in the price level from P1 to P2. The real output falls from Y1 to Y2.

The situation when the price level increases due to a supply-side shock in the economy with a simultaneous fall in real output, coupled with a rise in structural unemployment is a very specific economic situation: stagflation.

Stagflation is a period of slow economic growth, rising unemployment, and also rising inflation.

The causes of deflation

Several factors can cause deflation.

Firstly, the monetarist theory describes that it can occur due to the shortages or falling of the money supply in the economy. Additionally, a decrease in the velocity of money circulation could cause a fall in the general price level.

To learn more about how the money supply affects inflation read our explanation on the Monetarist Theory of Inflation.

Secondly, deflation could be caused by a fall in aggregate demand. A fall in the aggregate demand causes a fall in consumer confidence and therefore a fall in spending. This causes the general price level to fall. Firms may then react to this by decreasing wages to lower their costs of production. Lower wages will feed into lower households’ income, causing their demand to fall further. This is referred to as a deflation spiral.

A deflation spiral occurs when deflation affects the circular flow of income in a way that deflation in itself becomes a self-reinforcing loop.

Additionally, deflation can occur due to an increase in productivity. This can be influenced by improvements in technology, which reduce the costs of production, causing the aggregate supply to shift to the left and lower the overall price level in the economy.

Consequences of inflation and deflation

Let's explore the consequences that inflation and deflation have on the overall economy, consumers, and businesses.

The consequences of inflation

These are some of the consequences of inflation:

Consumers and employees

  • Decrease in consumers' purchasing power due to the increased prices of goods and services.

  • Inflation is favourable for consumers that have loans. Despite the increased prices of goods and income levels, the debt repayments stay at the same level, which makes them decrease in value. This makes it easier for consumers to repay their debts.

  • Along with inflation of the prices of goods and services, workers' income also increases. However, if it increases at a lower rate, consumers become less wealthy.

  • Due to inflation, businesses have to pay higher wages to their employees. To reduce the costs of labour, businesses may make cuts in employees by making them redundant.

  • High and unstable inflation affects agents’ expectation formation about future price levels, which in turn affects the economy in an unpredictable way.

To learn more about how expectation formation affects the price level in the economy take a look at our explanation on Monetarist Theory of Inflation

Businesses

Employees may be demanding higher wages due to inflation, which will result in the increase of the business costs of production. This can cause a reduction in exports as they will become relatively more expensive. For example, if there is inflation in the UK, the prices of goods in the UK will increase, therefore exports will become more expensive for foreign countries to import. This will result in lower demand for exports and an overall decrease in business profits from exports.

The consequences of deflation

These are some consequences of deflation:

  • In the long run, consumer spending declines. As prices are decreasing, consumers are likely to hold on to their savings, as in the future they believe that the costs of goods will be even lower.

  • Along with the decrease in the prices of goods, consumer salaries will decrease simultaneously.

  • There is a decline in business productivity due to the lower demand for consumer goods. This results in an increase in unemployment as businesses will not need to supply as many goods.

  • As a result of deflation, price mechanisms are disrupted, which makes people confused about the true value of products and services. This also affects their expectation formation about future price levels.

  • Deflation causes an overall slowdown in the economy.

Examples of inflation and deflation

Let’s explore some examples of how inflation and deflation affect the UK and the rest of the world.

Changes in other economies affect inflation and deflation in the UK

The global increase in prices of goods that the UK imports, such as oil, raw materials, food, and others causes the price of these products to increase when they are imported into the UK.

For example, the oil prices increased significantly during 2008 and 2011-12, which influenced inflation in the UK. How did that happen? The higher oil prices caused plastic manufacturing costs to increase. Due to this, the plastic production companies passed increased prices of plastic goods onto consumers, and this caused inflation of goods containing plastic.

On the other hand, the global economy can have an influence on inflation to slow it down and even cause deflation. For example, rising productivity and technology lower the prices of goods in major exporter countries such as China. If the UK increases its imports from China, this will reduce the prices of those goods sold in the UK.¹

Changes in world commodity prices affect domestic inflation

Commodity prices usually respond to changes in the exchange rate of the US dollar. If the dollar increases in value the commodities such as oil and gas will increase in prices in the domestic economies.

Shocks in the economy such as natural disasters increase the export cost of commodities. Therefore, once the commodity gets to the consumer, its price is higher, which results in domestic inflation for that particular commodity.

Controlling inflation and deflation

High deflation and inflation rates can be bad for the economy. Deflation slows down economic growth, while inflation causes a decrease in the consumers’ purchasing power. It also disturbs savings because as money loses value, consumers are likely to spend their money instead of saving it. Therefore, the government and central banks implement various techniques and policies to control inflation and deflation rates.

To control inflation, the government uses different macroeconomic policies. This is aimed to deflate the economy. That is, decreasing the economic activity and aggregate demand to regulate the price levels of goods and services. The main government’s aim is to achieve disinflation.

Disinflation is the situation when the rate of inflation is decreasing. In other words, the prices are rising at a slower rate. This applies to a positive inflation rate only.

To control deflation, the government and central banks implement monetary and fiscal policies. The central bank uses monetary policy to lower the reserve limits and generate more loans for various investments and consumption. That way, there is increased demand for borrowing, which stimulates aggregate demand and supply.

Additionally, the government can use fiscal policy to increase spending and increase the aggregate demand. To achieve this, the government can provide funds and grants to businesses so that they can employ more people. This would mean that households would have more purchasing power due to more employment, which would result in increased consumer spending. This will increase the demand for goods and services and their prices simultaneously.

High inflation and deflation are bad for the economy, which is why government implements policies to control them. The government’s overall goal is to achieve low and stable inflation, which is very important for a balanced economy.

Inflation and Deflation - Key takeaways

  • Inflation means that the price levels in an economy are rising.
  • There are two types of inflation: demand pull-inflation and cost-push inflation.
  • Demand-pull inflation is caused by an increase in aggregate demand.
  • Cost-push inflation arises due to issues in the supply-side of the economy.
  • Stagflation is an economic situation that describes a period of slow economic growth, rising unemployment, and rising inflation.
  • Deflation is opposite to inflation and it means that prices of goods and services are decreasing.
  • The consequences of inflation include reduced consumer purchasing power, a decrease in loan repayments, an increase in the level of income, and increased costs of production.
  • The consequences of deflation include a decrease in consumer spending and income, a decrease in business production, and an overall slowdown in the economy.
  • To control inflation, the government uses different policy tools, the main being Monetary Policy.
  • Disinflation is the situation when the rate of inflation is decreasing. In other words, the prices are rising at a slower rate. This applies to a positive inflation rate only.

  • To control deflation, the government and central banks usually use fiscal and monetary policies. The use of these policies involves increasing bank reserves to lend more money to the citizens and giving funds to businesses so they can increase production and employ more workers. These methods are aimed to increase consumers' purchasing power and demand for goods which should improve the situation of deflation.

Sources

1. Tejvan Pettinger, Impact of the global economy on UK inflation, 2013.

Frequently Asked Questions about Inflation and Deflation

Different types of inflation are caused by different factors. Demand-pull inflation is mainly caused by an increase in aggregate demand. Cost-push inflation is generally caused by issues in the supply-side of the economy such as increased union power in the wage bargaining process or an increase in either commodity or energy prices.


Deflation usually occurs due to the following reasons. There may be a fall in aggregate demand, which would cause the general price level to decrease. Alternatively, the short-run aggregate supply could shift to the right due to decreased costs of production, causing the general price levels in the economy to fall.

Inflation is an economic problem due to a number of reasons such as the reduction in consumers' purchasing power. If income grows slower than the prices of goods and services, it results in people being able to afford less. For business, inflation increases the costs of production which results in reduced demand for exports.

 

On the other hand, deflation slows down the economy as people are likely to spend less and hold on to their savings as they believe that in the future their money will be worth more. Due to the lower demand for goods, businesses' production decreases, and unemployment increases.

  1. Decrease in consumer purchasing power as the prices of goods increase.

  2. Loans become easier to repay because of inflation of prices of goods and income levels, but the level of debt repayments stays the same.

  3. Due to inflation, employees may be demanding higher wages which will cause the costs of production to increase.

The main difference between inflation and deflation is that inflation causes the prices of goods to increase along with the employees' salaries. On the other hand, deflation means that the prices of goods and services are decreasing along with employees' salaries.

Final Inflation and Deflation Quiz

Question

What is the definition of inflation?


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Answer

The progressive increase in prices of goods and services in an economy.


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Question

What are the key types of inflation?


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Answer

Demand pull-inflation and cost-push inflation.

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Question

What is cost-push inflation?


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Answer

Cost-push inflation arises due to issues in the supply-side of the economy. It can occur due to the increased union power in the wage bargaining process, or through an increase in either

commodity and energy prices.

Show question

Question

What is the definition of deflation?


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Answer

Deflation is the opposite of inflation. It means that prices of goods and services in an economy fall. 


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Question

What are the key methods used to calculate inflation?


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Answer

Retail price index (RPI) and Consumer price index (CPI).


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Question

Is the retail price index (RPI) method used currently?


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Answer

No, it was only used until 2003.


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Question

What is CPI in economics?


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Answer

CPI means consumer price index. The CPI method is used to calculate the rate of inflation of the ‘national shopping basket,’ which includes the essential consumer goods.


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Question

What is the main cause of demand-pull inflation? 

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Answer

An increase in the aggregate demand.

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Question

What are the main causes of cost-push inflation?


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Answer

Cost-push inflation arises due to issues in the supply-side of the economy such as:

  • Increased union power in the wage bargaining process or
  • Increase in either commodity or energy prices.

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Question

What is stagflation?


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Answer

Stagflation is an economic situation that describes a period of slow economic growth, rising unemployment, but also rising inflation.

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Question

What are the main causes of deflation?


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Answer

The main causes of deflation are:

  • Shortages of money supply in the economy.
  • The imbalance of supply and demand. The supply is higher than demand. 
  • A sudden increase in productivity influenced by the improvements in technology which makes costs of production less expensive.


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Question

What are the main consequences of inflation?


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Answer

The main consequences of inflation are:

  • Decrease in consumer purchasing power.
  • Making debt repayments cheaper for the consumers.
  • If prices of goods increase faster than consumers’ incomes it makes consumers less wealthy.
  • The business may make cuts in employees, due to increased labour costs.
  • An increase in employees' wages result in higher costs of production.
  • Decrease in demand for exports.


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Question

What are the main consequences of deflation?

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Answer

The main consequences of deflation are:

  • Decrease in consumer spending.
  • Decrease in prices of goods along with employees' wages.
  • Causes an overall slowdown in the economy.


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Question

Can you give a real-world example of how inflation was caused?


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Answer

For example, the oil prices increased significantly during 2008 and 2011-12, which influenced inflation in the UK. How did that happen? The higher oil prices caused plastic manufacturing costs to increase. Due to this, the plastic production companies passed increased prices of plastic goods onto consumers, and this caused inflation of goods containing plastic. 

Show question

Question

What is the key method used to control inflation?


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Answer

Although there are various ways to control inflation, Monetary Policy is the main tool as it involves the manipulation of the interest rates.

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Question

What are the key methods used to control deflation?


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Answer

The key method used to control deflation are:

  • Fiscal policy, which is used by the government to increase spending and escalate the aggregate demand.
  • Monetary policy, used by the central bank to lower the reserve limits and generate more loans for investments and consumption.


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Question

 What is disinflation?


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Answer

Disinflation occurs when the rate of inflation is decreasing, in other words, the prices are rising at a slower rate. This applies to a positive inflation rate only.

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Question

What is the monetarist theory of inflation?

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Answer

The monetarist theory of inflation states that excess in money supply is what causes inflation.

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Who is one of the key thinkers of monetarist theory?

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Answer

Milton Friedman.

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Question

What economic theory has a major influence on the Monetarist Theory of Inflation?

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Answer

Quantity Theory of Money. 

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What is the oldest known theory of inflation?

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Answer

The Quantity Theory of Money. 

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What are the key points to consider regarding the quantity theory of money?

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Answer


  1. The quantity theory of money states that inflation is caused by a continuous increase in the money supply. 
  2. The quantity theory describes a situation where the government supplies too much money in relation to national output. This leads to people having excess money, which increases the prices of goods and services.
  3. In fact, the quantity theory was developed by economist Irving Fisher in the 20th century, who developed the theory using a concept he called an equation of exchange.

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Question

In monetarist's view, how can inflation be avoided?

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Answer

In monetarists view, if the supply of money is under control, inflation can be avoided.

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What is the quantity theory's equation of exchange?

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Answer

Money supply (stock of money) X the velocity of circulation of money = price level X quantity of output or can be written as: MV = PQ.


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How do monetarists see the equation of exchange? 

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In the monetarist view, the velocity of circulation (V), which corresponds to the speed at which money is circulated around the economy is seen as unstable, so when money supply (M) increases, there is an increase in purchases of goods and services. Nevertheless, if there is no increase in real output, this will cause prices to rise, causing inflation.

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What is the Keynesians economists criticism regarding the quantity of exchange theory?

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Answer

The quantity theory has been criticised by Keynesian economists, as they argue that when the supply of money (M) increases, it is controlled by the slowdown in the velocity of circulation  (V), meaning the extra money is not spent on either goods or services, but on investments on capital assets, which is likely to stimulate aggregate demand and economic growth, therefore increasing quantity of output (Q) rather than price level (P).


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Question

What are the key differences between Monetarists and Keynesians?

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Answer

There are a few major differences that differentiate Keynesians and Monetarists, these are:

  • Causes of unemployment. Keynesians believe that it's caused by demand deficiency, while monetarists believe that unemployment occurs due to immobility of labour or due to labour switching occupations.
  • Controlling unemployment. Keynesians believe that the government can control unemployment by implementing fiscal policies, while monetarists believe that unemployment can be reduced when the market functions as a whole accompanied by supplied-side policies.
  • Inflation. Monetarists believe that inflation is caused by an excess supply of money while Keynesian believes that inflation is caused by imbalances of aggregate demand and supply.

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Question

What does inflation mean?

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Answer

Inflation refers to the rise in the price level in the economy.

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What does deflation mean?

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Deflation refers to the fall in the price level in the economy.

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Question

Can you give an example of how people's expectations can influence inflation in the economy?

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Answer

For example, people predicting inflation might behave in an inflationary way, like trade unions and employees perhaps engaging in behaviours like bargaining, this has the effect of increasing production costs, which in turn raises the prices of products and services.

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Question

Inflation expectations may lead to several consequences. What are they?

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Answer

The consequences of expectations regarding inflation can result in:

  •  Unequal distribution of money, 
  • Decreasing the function of money, 
  • Disturbing normal consumer behaviour, 
  • Making consumers waste their time by comparing prices,  
  • Increases uncompetitiveness in international trade.

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Question

Can you give an example of how deflation expectations can affect the economy?

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For example, if people are expecting deflation to happen this can make them delay big purchases such as buying a house as they believe that in the future it will be at a lower price. However, this consumers behaviour can trigger a recession as this situation can cause a decrease in demand for products, loss of business confidence, increased unemployment and an overall decrease in economic growth.

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Can you give an example of a good deflation?

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Answer

An example of a good deflation is when deflation has been caused by the reduction in business costs of production due to improvement in the supply side of the economy. This allows businesses to sell products and services at a lower price along with this output and employment will increase.

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What is bad deflation?

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Answer

An example of a bad deflation is when the prices of products and services drop along with the aggregate demand. Bad deflation can be triggered by a credit crunch or negative multiplier effects. Moreover, bad deflation can cause negative effects on the economy such as increased unemployment and business failures. 

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Question

What is another word for bad deflation?

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Answer

Malign deflation.

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