Question

a) Using a numerical example, show how inflation can be measured. (5 marks)

b) Outline how deflation can be a worse off situation than inflation. (5 marks)

c) With the aid of diagrams, explain the relationship between inflation and unemployment. (10 marks)

d) Discuss the impact of inflation.

Answer 1

1)Inflation is an increase in the level of prices of the goods and services that households buy. It is measured as the rate of change of those prices. Typically, prices rise over time, but prices can also fall (a situation called deflation).

The most well-known indicator of inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of a basket of goods and services consumed by households.

o better understand how inflation is calculated we can use an example. In this example we calculate inflation for a basket that has two items in it – books and childcare. The formula for calculating inflation for a single item is below.

Inflation = Price year 2 - Price year 1 x 100 Price year 1

The price of a book was $20 in 2016 (year 1) and the price increased to $20.50 in 2017 (year 2). The price of an hour of childcare was $30 in 2016, and this increased to $31.41 in 2017.

2)The opposite of deflation is inflation. Inflation is when prices rise over time. Both economic responses are very difficult to combat once entrenched because people's expectations worsen price trends. When prices rise during inflation, they create an asset bubble. This bubble can be burst by central banks raising interest rates. Former Fed Chairman Paul Volcker proved this in the 1980s. He fought double-digit inflation by raising the fed funds rate to 20%. He kept it there even though it caused a recession. He had to take this drastic action to convince everyone that inflation could actually be tamed. Thanks to Volcker, central bankers now know the most important tool in combating inflation or deflation is controlling people's expectations of price changes.Once rates have hit zero, central banks must use other tools. But as long as businesses and people feel less wealthy, they spend less, reducing demand further. They don't care if interest rates are zero because they aren't borrowing anyway. There's too much liquidity, but it does no good. It's like pushing a string. That deadly situation is called a liquidity trap and is a vicious, downward spiral.

3)The Phillips curve shows the inverse relationship between inflation and unemployment: as unemployment decreases, inflation increases.The Phillips curve relates the rate of inflation with the rate of unemployment. The Phillips curve argues that unemployment and inflation are inversely related: as levels of unemployment decrease, inflation increases. The relationship, however, is not linear. Graphically, the short-run Phillips curve traces an L-shape when the unemployment rate is on the x-axis and the inflation rate is on the y-axis

Short-run Phillips curve: Inflation rate (%) 6 ----- B 3 5 SRPC1 Unemployment rate (%)

d)When prices rise for energy, food, commodities, and other goods and services, the entire economy is affected. Rising prices, known as inflation, impact the cost of living, the cost of doing business, borrowing money, mortgages, corporate and government bond yields, and every other facet of the economy.Inflation can be both beneficial to economic recovery and, in some cases, negative. If inflation becomes too high the economy can suffer; conversely, if inflation is controlled and at reasonable levels, the economy may prosper. With controlled, lower inflation, employment increases. Consumers have more money to buy goods and services, and the economy benefits and grows. However, the impact of inflation on economic recovery cannot be assessed with complete accuracy. Some background details will explain why the economic results of inflation will differ as the inflation rate varies.

GDP

Economic growth is measured in gross domestic product (GDP), or the total value of all goods and services produced. The percentage of growth or decline, compared to the previous year, is adjusted for inflation. Therefore, if growth was 5% and inflation was 2%, GDP would be reported at 3%.

As prices rise, the value of the dollar declines, as its purchasing power erodes with each increase in the price of basic goods and services.

The Cost of Borrowing

Low or no inflation, theoretically, may help an economy recover from a recession or a depression. With both inflation and interest rates low, the cost of borrowing money for investments or borrowing for the purchase of big-ticket items, such as automobiles or securing a mortgage on a house or condo, is also low. These low rates are expected to encourage consumption, say some economists.

Banks and other lending institutions, however, may be reluctant to lend money to consumers when rates of return on loans are low, which decreases profit margins. Businesses can plan their borrowing, hiring, marketing, improvement and expansion strategies accordingly. Investors, likewise, know roughly what government and corporate bonds and other debt will return since most of these instruments are pegged to Treasury yields.

However, economists differ notoriously in their opinions. Some economists claim that a 6% inflation rate for several years would help the economy by helping to resolve the U.S. debt problem, lifting wages and stimulating economic growth.

The Consumer Price Index

The standard measurement of inflation is the government's Consumer Price Index (CPI). Components of the CPI include a "basket" of certain elementary goods and services, such as food, energy, clothing, housing, medical care, education, and communication and recreation. If the average price of all goods and services in the CPI were to go up 3% over the previous year's level, for example, then inflation would be pegged at 3%. This also means that the purchasing power of the dollar would have declined by 3%.

Hard assets, such as a home or real estate, often increase in value as the CPI rises; however, fixed income instruments lose value because their yields don't increase with inflation. Treasury inflation-protected securities (TIPS) are a notable exception, however. Interest on these securities is paid twice yearly at a fixed rate as the principal increases in step with the CPI, thus protecting the investment against inflation.