1. **Price stability** is a fundamental **macroeconomic goal** for any economy. 2. As we will discover in this section, when prices r**emain relatively stable:** 1. Consumers can make confident spending decisions. 2. Businesses can plan investments effectively. 3. The overall economy can function more efficiently. ## Measuring inflation using the consumer price index (CPI) [block_0] A **measure** of the **cost of living** carried out by comparing the **value** **of a basket of goods** **and** **services** in a given year to a **base** **year**. 1. The CPI is used by economies worldwide to track inflation (or deflation). 2. It does so based on the percentage change in the basket's value over time. [{"_key":"efd4c6573a93","_type":"block","asset":null,"children":[{"_key":"95959b1cf0b6","_type":"span","marks":[],"text":"Calculating a weighted price index (HL Only)"}],"markDefs":[],"style":"h3"},{"_key":"d40a1c13ae62","_type":"block","asset":null,"children":[{"_key":"271dc1e00961","_type":"span","marks":[],"text":"HL students must be able to construct "},{"_key":"af93b39aa298","_type":"span","marks":["strong"],"text":"weighted price indices"},{"_key":"3cc820cf3c73","_type":"span","marks":[],"text":" from raw data. The example below note shows how it can be done, step by step:"}],"markDefs":[],"style":"normal"},{"_key":"311f335b8d59","_type":"table","asset":null,"rows":[{"_key":"052df9a4-5051-4728-aeae-e60c78d5cc33","_type":"tableRow","cells":["Good/Service","Weight (%)","Price Year 1 ($)","Price Year 2 ($)"]},{"_key":"c44a18e0-82e7-4395-9681-a41f71b4d720","_type":"tableRow","cells":["Food ","35","100","120"]},{"_key":"09397f56-b652-43a3-9b14-62ac52016e6d","_type":"tableRow","cells":["Housing","40","200","230"]},{"_key":"f61f604e-1581-4cda-85b9-2c7624aed788","_type":"tableRow","cells":["Transport","15","150","170"]},{"_key":"b4d7065e-823c-4021-ac4b-46253f07fa22","_type":"tableRow","cells":["Clothing","10","80","85"]}]},{"_key":"9e343592d50e","_type":"block","asset":null,"children":[{"_key":"595a89a7a6180","_type":"span","marks":[],"text":"Step 1: calculate percentage changes in prices"}],"markDefs":[],"style":"h4"},{"_key":"f1ec1c373201","_type":"block","asset":null,"children":[{"_key":"80c90956c7050","_type":"span","marks":[],"text":"The "},{"_key":"d6b9ed5cf6dd","_type":"span","marks":["strong"],"text":"percentage"},{"_key":"27a6bdac7543","_type":"span","marks":[],"text":" "},{"_key":"ec6db66107fb","_type":"span","marks":["strong"],"text":"change"},{"_key":"86bea28a09b8","_type":"span","marks":[],"text":" "},{"_key":"54765c6672a7","_type":"span","marks":["strong"],"text":"in"},{"_key":"aedf8e86fa7b","_type":"span","marks":[],"text":" "},{"_key":"d2a650197dd1","_type":"span","marks":["strong"],"text":"price"},{"_key":"0898740f0518","_type":"span","marks":[],"text":" for each category is calculated using the formula:"}],"markDefs":[],"style":"normal"},{"_key":"d5fbd7a60084","_type":"block","asset":null,"children":[{"_key":"733d961735fc0","_type":"span","marks":[],"text":"$$Price Change=\\frac{\\text{New Price}}{\\text{Old Price}} \\times 100$$"}],"markDefs":[],"style":"normal"},{"_key":"f6cbfcf8b966","_type":"block","asset":null,"children":[{"_key":"e4087a8b68420","_type":"span","marks":[],"text":"Applying this formula to different goods:"}],"markDefs":[],"style":"normal"},{"_key":"bcb5af73ad4b","_type":"block","asset":null,"children":[{"_key":"87bb54bbaa75","_type":"span","marks":[],"text":"$$\\text{Food} = \\left( \\frac{120}{100} \\right) \\times 100$$"}],"markDefs":[],"style":"normal"},{"_key":"2e1a161d40a8","_type":"block","asset":null,"children":[{"_key":"53b1de4c648f","_type":"span","marks":[],"text":"$$\\text{Housing} = \\left( \\frac{230}{200} \\right) \\times 100$$"}],"markDefs":[],"style":"normal"},{"_key":"8a40070a80cc","_type":"block","asset":null,"children":[{"_key":"044bc4cd39c7","_type":"span","marks":[],"text":"$$\\text{Transport} = \\left( \\frac{170}{150} \\right) \\times 100$$"}],"markDefs":[],"style":"normal"},{"_key":"578f550e123c","_type":"block","asset":null,"children":[{"_key":"31404c50ca73","_type":"span","marks":[],"text":"$$\\text{Clothing} = \\left( \\frac{85}{80} \\right) \\times 100$$"}],"markDefs":[],"style":"normal"},{"_key":"e501512b558f","_type":"block","asset":null,"children":[{"_key":"02995b71b9780","_type":"span","marks":[],"text":"Step 2: apply weights to each category"}],"markDefs":[],"style":"h4"},{"_key":"9ccc7c98cfb3","_type":"block","asset":null,"children":[{"_key":"73970ae45ab10","_type":"span","marks":[],"text":"Each category is "},{"_key":"73970ae45ab11","_type":"span","marks":["strong"],"text":"weighted based on its relative importance"},{"_key":"73970ae45ab12","_type":"span","marks":[],"text":" in "},{"_key":"59efa94dfbc8","_type":"span","marks":["strong"],"text":"consumer spending"},{"_key":"a4ef2a74d866","_type":"span","marks":[],"text":". The formula for applying weights is:"}],"markDefs":[],"style":"normal"},{"_key":"296d34c6d995","_type":"block","asset":null,"children":[{"_key":"208f4ee98e6b0","_type":"span","marks":[],"text":"$$\\text{Weighted Value} = \\text{Price Index} \\times \\text{Weight}$$"}],"markDefs":[],"style":"normal"},{"_key":"0ed0a9046d02","_type":"block","asset":null,"children":[{"_key":"9a2b5cf1feab","_type":"span","marks":[],"text":"Therefore:"}],"markDefs":[],"style":"normal"},{"_key":"af2eae840935","_type":"block","asset":null,"children":[{"_key":"e66f7c9574de","_type":"span","marks":[],"text":"$$\\text{Food} = 120 \\times 0.35 = 42.0$$"}],"markDefs":[],"style":"normal"},{"_key":"a4a9a9faf089","_type":"block","asset":null,"children":[{"_key":"a8d8467ddf01","_type":"span","marks":[],"text":"$$\\text{Housing} = 115 \\times 0.40 = 46.0$$"}],"markDefs":[],"style":"normal"},{"_key":"34ce90ed69a8","_type":"block","asset":null,"children":[{"_key":"23367e5d3ec9","_type":"span","marks":[],"text":"$$\\text{Transport} = 113.3 \\times 0.15 = 17.0$$"}],"markDefs":[],"style":"normal"},{"_key":"7e61d6cb2f9e","_type":"block","asset":null,"children":[{"_key":"c3e38a3e2110","_type":"span","marks":[],"text":"$$\\text{Clothing} = 106.3 \\times 0.10 = 10.6$$"}],"markDefs":[],"style":"normal"},{"_key":"8473d63922b8","_type":"block","asset":null,"children":[{"_key":"30e3fead6e1b0","_type":"span","marks":[],"text":"Step 3: calculate the weighted price index"}],"markDefs":[],"style":"h4"},{"_key":"577dcb4bac1a","_type":"block","asset":null,"children":[{"_key":"22b9301994320","_type":"span","marks":[],"text":"To obtain the "},{"_key":"22b9301994321","_type":"span","marks":["strong"],"text":"overall weighted price index"},{"_key":"22b9301994322","_type":"span","marks":[],"text":", sum all the weighted values:"}],"markDefs":[],"style":"normal"},{"_key":"c67daabfd9b5","_type":"block","asset":null,"children":[{"_key":"e0ae34c31bb90","_type":"span","marks":[],"text":"$$\\text{Weighted Price Index} = 42.0 + 46.0 + 17.0 + 10.6 = 115.6$$"}],"markDefs":[],"style":"normal"}] ### Calculating inflation [c1be5777a108] With the **CPI** provided, the **inflation rate **can be calculated by using this formula: $$\text{Inflation Rate}=\frac{(100\text{Weighted Price Index}−100)} \times 100$$ | Year | Consumer Price Index (CPI) | Inflation Rate (%) | | --- | --- | --- | | 2020 (Base Year) | 100 | - | | 2021 | 105 | 5.00% | | 2022 | 110 | 4.76% | | 2023 | 120 | 9.09% | | 2024 | 125 | 4.17% | [{"_key":"ee422e4584dd","_type":"block","asset":null,"children":[{"_key":"c531d01d89e7","_type":"span","marks":[],"text":"The "},{"_key":"f1be1f9ce2a8","_type":"span","marks":["strong"],"text":"base year's CPI "},{"_key":"6b7d8a447c61","_type":"span","marks":[],"text":"is always equal to 100.0. This is because it is expressed as an "},{"_key":"b91fd8c3d181","_type":"span","marks":["strong"],"text":"index"},{"_key":"514e6c992beb","_type":"span","marks":[],"text":"."}],"markDefs":[],"style":"normal"}] _Table 1 _above shows the **CPI data** for an imaginary economy, Econland. The** inflation rate** for each year can be calculated by using the formula above. #### From Year 1 to Year 2: [4826696a0f80] * CPI in Year 2 = **105** * CPI in Year 1 = **100** * Inflation Rate: $\left( \frac{105 - 100}{100} \right) \times 100 = 5.00\%$ #### From Year 2 to Year 3: [47b6fbce8a89] * CPI in Year 3 = **110** * CPI in Year 2 = **105** * Inflation Rate: $\left( \frac{110 - 105}{105} \right) \times 100 = 4.76\%$ #### From Year 3 to Year 4: [4cc02642ef0f] * CPI in Year 4 = **120** * CPI in Year 3 = **110** * Inflation Rate: $\left( \frac{120 - 110}{110} \right) \times 100 = 9.09\%$ #### From Year 4 to Year 5: [9f7b33aab4e9] * CPI in Year 5 = **125** * CPI in Year 4 = **120** * Inflation Rate: $\left( \frac{125 - 120}{120} \right) \times 100 = 4.17\%$ [{"_key":"7bd3427fcc2f","_type":"block","asset":null,"children":[{"_key":"cd11e0345b1b0","_type":"span","marks":[],"text":"Don't forget to convert your weights to decimals when calculating! 40% should be written as 0.40, not 40."}],"markDefs":[],"style":"normal"}] [{"_key":"190e5a85424b","_type":"block","asset":null,"children":[{"_key":"89347caf60510","_type":"span","marks":[],"text":"In IB exams, you may need to calculate "},{"_key":"6c6b3f1f9d9c","_type":"span","marks":["strong"],"text":"CPI and inflation rates"},{"_key":"6b1b5466bb72","_type":"span","marks":[],"text":". "}],"markDefs":[],"style":"normal"},{"_key":"91de6cf4f6b4","_type":"block","asset":null,"children":[{"_key":"30bc0b9b6c6f","_type":"span","marks":[],"text":"Focus on showing clear steps in your calculations: it helps earn method marks even if you make a small arithmetic error."}],"markDefs":[],"style":"normal"}] ## The limitations of the CPI in measuring inflation [c32b30e86657] Several **limitations** affect **CPI's accuracy** as a measure of **inflation**. Some of these limitations include: 1. **Substitution bias:** 1. When **prices rise**, consumers switch to **cheaper alternatives**. 2. **CPI** uses **fixed weights** and doesn't capture these changes. 3. Results in** overestimating** actual cost increases. 2. **Quality changes:** 1. **New **quality improvements **aren't fully reflected**. 2. Therefore, **price** **increases** due to **quality** **improvements** are counted as **inflation**. 3. **New products:** 1. The **CPI basket** takes time to** incorporate new products** **and** **services**. 2. This delay means important **consumption change**s aren't **quickly** **reflected.** 3. Thus, the index can **become** **outdated** in **rapidly** **evolving** **markets**. 4. **Regional differences:** 1. **CPI** uses **national average prices** that don't reflect **local/regional variations**. 2. In reality, **living costs** can vary significantly between **urban** and **rural areas**. 3. A **single national figure** may not represent any **actual location's experience**. [{"_key":"445d8d636236","_type":"block","asset":null,"children":[{"_key":"c76ff9574de90","_type":"span","marks":[],"text":"Substitution bias in action"}],"markDefs":[],"style":"h4"},{"_key":"829fcde7cd8c","_type":"block","asset":null,"children":[{"_key":"ce1c79feee4a","_type":"span","marks":[],"text":"When coffee prices rise sharply, consumers might switch from premium brands to cheaper alternatives. The CPI assumes they continue buying the expensive brand, overstating the actual cost increase."}],"markDefs":[],"style":"normal"}] ## Causes of inflation [block_37] There are two types of inflation studied in the IB curriculum:** demand-pull inflation** and **cost-push inflation**. ### Demand-pull inflation [block_38] A type of inflation caused by an **increase in aggregate demand** that **exceeds aggregate supply** at the **full employment level**. **Demand-pull inflation** is represented in the AD-AS model by a **rightward shift** in the **aggregate demand (AD) curve **(_Figure 1_). ![](https://cdn.sanity.io/images/w7j7fz60/production/9d8f6a8917a7caf09ef8c3d2ecf0a211c0e15579-2398x1732.png) 1. At initial **equilibrium** ($E_1$) the market is in balance. The **price level** is at $PL_1$, and the **real output** is at $Y_1$. 2. As **aggregate demand** increases (due to an increase in one of tis components), the **AD curve shifts rightward **($AD_1$ → $AD_2$). 3. As a result, **price level** **rises** ($PL_1$ → $PL_2$), and **output** **increases** ($Y_1$ → $Y_2$). This shows both **inflation** and **economic** **growth**. 4. As seen, **higher aggregate demand** has pulled **prices** **upwards**. 5. Since **output** cannot expand enough **to** **meet** **all** **new** **demand**, **demand-pull inflationary pressures rise**. [{"_key":"f32e182dd4b1","_type":"block","asset":null,"children":[{"_key":"3548ae1dfc620","_type":"span","marks":["strong"],"text":"During post-COVID economic recovery "},{"_key":"49638ac8211b","_type":"span","marks":[],"text":"("},{"_key":"4ea8cfec1b2e","_type":"span","marks":["strong"],"text":"2021-22"},{"_key":"72ac75f41bfd","_type":"span","marks":[],"text":"), government stimulus worldwide "},{"_key":"42b224c571bc","_type":"span","marks":["strong"],"text":"increased"},{"_key":"f68be3329759","_type":"span","marks":[],"text":" "},{"_key":"da472692836b","_type":"span","marks":["strong"],"text":"consumer"},{"_key":"dd3f5d46f38e","_type":"span","marks":[],"text":" "},{"_key":"a5d37183a567","_type":"span","marks":["strong"],"text":"spending"},{"_key":"f7a3bdfa4e5f","_type":"span","marks":[],"text":" dramatically. With supply chains still constrained, this surge in "},{"_key":"053231cc8bec","_type":"span","marks":["strong"],"text":"aggregate demand"},{"_key":"d1c02b0364ee","_type":"span","marks":[],"text":" led to significant "},{"_key":"c11b9f798c7a","_type":"span","marks":["strong"],"text":"price level increases"},{"_key":"889e9233c8f6","_type":"span","marks":[],"text":" across many sectors."}],"markDefs":[],"style":"normal"},{"_key":"14b4e443deb7","_type":"block","asset":null,"children":[{"_key":"df77ee0c2dc30","_type":"span","marks":[],"text":""}],"markDefs":[],"style":"normal"}] [{"_key":"block_50","_type":"block","asset":null,"children":[{"_key":"Ck70Ri4yn6Tjn6QD5bL1xd","_type":"span","markDefs":[],"marks":[],"text":"Remember that "},{"_key":"0fb2291304ff","_type":"span","markDefs":[],"marks":["strong"],"text":"demand-pull inflation"},{"_key":"966c5e438434","_type":"span","markDefs":[],"marks":[],"text":" is often associated with periods of "},{"_key":"46cde4affac0","_type":"span","markDefs":[],"marks":["strong"],"text":"strong economic growth"},{"_key":"e4ad72251465","_type":"span","markDefs":[],"marks":[],"text":" and "},{"_key":"0163ea636585","_type":"span","markDefs":[],"marks":["strong"],"text":"low unemployment"},{"_key":"8b1bbef27d0d","_type":"span","markDefs":[],"marks":[],"text":"."}],"markDefs":[],"style":"normal"}] ### Cost-push inflation [block_51] A type of inflation caused by **rising** **production** **costs**, such as **higher** **wages** or **input** **prices**, which **reduce** **aggregate** **supply** and **push the** **price level** **up**. **Cost-push inflation **is shown in the AD-AS model by a l**eftward shift** of the **AS curve **(_Figure 2_). ![](https://cdn.sanity.io/images/w7j7fz60/production/23f2bb3b81e6c4aa81947a8ed73b02844e36ca16-2400x1732.png) 1. The initial **equilibrium** ($E_1$) represents normal market conditions. At this point, $AD$ intersects $SRAS_1$, the economy is at **price** **level** $PL_1$ and **real output** $Y_1$. 2. Increased **production** **costs** across the economy can create a **supply** **shock**, causing the **supply curve to shift leftwards** ($SRAS_1$ → $SRAS_2$). 3. As the price level rises ($PL_1$ → $PL_2$), the output falls from ($Y_1$ → $Y_2$). This shows **stagflation: **a situation where there is **inflation** and **falling levels of real output**. [{"_key":"36a0701498a2","_type":"block","asset":null,"children":[{"_key":"bd65af6dae99","_type":"span","marks":[],"text":"During the "},{"_key":"cd9c4c56e09c0","_type":"span","marks":["strong"],"text":"2022-23 energy crisis following the Russia-Ukraine conflict"},{"_key":"d1b570a6acc0","_type":"span","marks":[],"text":", rising oil and gas prices "},{"_key":"89e89445b059","_type":"span","marks":["strong"],"text":"increased"},{"_key":"f206807d7343","_type":"span","marks":[],"text":" "},{"_key":"98df94be0999","_type":"span","marks":["strong"],"text":"production costs"},{"_key":"cccd4229ba0c","_type":"span","marks":[],"text":" across all sectors, forcing businesses to raise prices even as "},{"_key":"69072c0de528","_type":"span","marks":["strong"],"text":"aggregate demand"},{"_key":"1e0604bd33fb","_type":"span","marks":[],"text":" remained stable or fell."}],"markDefs":[],"style":"normal"},{"_key":"4cb67ac7c482","_type":"block","asset":null,"children":[{"_key":"0acef879434a0","_type":"span","marks":[],"text":""}],"markDefs":[],"style":"normal"}] [{"_key":"fcd284daedac","_type":"block","asset":null,"children":[{"_key":"e55ff45d96b50","_type":"span","marks":[],"text":"Don't confuse the shifts! Cost-push shows SRAS moving left, while demand-pull shows AD moving right. The different effects on output help distinguish them."}],"markDefs":[],"style":"normal"},{"_key":"51622c59fe53","_type":"block","asset":null,"children":[{"_key":"f491a5dae7e70","_type":"span","marks":[],"text":""}],"markDefs":[],"style":"normal"}] ## Costs of a high inflation rate [block_65] **High inflation** creates several serious problems that can damage an **economy's performance** and **people's well-being**. Some of these problems are shown below: 1. **Uncertainty makes planning difficult:** 1. Businesses struggle to plan future investments because they can't predict future costs. 2. Workers don't know if their wages will keep up with rising prices. 3. Long-term contracts become risky as money loses value over time. 2. **Creates unfair winners and losers:** 1. People with savings lose purchasing power as their money becomes worth less. 2. Borrowers benefit because they repay loans with money worth less than when they borrowed. 3. Fixed-income earners (like pensioners) suffer as their income buys less over time. 3. **Discourages saving:** 1. Money loses value the longer you hold it, so it is not beneficial to save. 2. Thus, people rush to spend rather than save, creating even more inflation. 3. Makes it harder for people to save for big purchases or retirement. 4. **Hurts international trade** 1. Higher domestic prices make exports more expensive. 2. As a result, foreign buyers switch to cheaper alternatives from other countries. 3. Trade deficit often worsens as a result. 5. **Slows economic growth:** 1. Investment decreases due to uncertainty. 2. Resources get wasted trying to protect against inflation. 3. Overall productivity falls as businesses focus on coping with inflation rather than improving efficiency. ## Causes of deflation [block_91] A sustained decrease in the general price level of goods and services in an economy over time, typically indicated by a negative inflation rate. **Deflation** can be caused due to either an **AD** **curve** **shifting** **left** or an **SRAS** **curve** **shifting** **right**: 1. As the **AD curve shifts left **($AD_1$ → $AD_2$) due to (for example) reduced spending in the economy, **price levels** **go** **down** ($PL_1$ → $PL_2$) together with **real** **output **($Y_1$ → $Y_2$). 2. As the **SRAS curve shifts right** ($SRAS_1$ → $SRAS_2$) due to (for example) **lower production costs** or **higher productivity**, **price levels go down** $PL_1$ → $PL_2$, while **output increases** ($Y_1$ → $Y_2$). 3. These shifts can be visualised in _Figure 3 _below. ![](https://cdn.sanity.io/images/w7j7fz60/production/f1e8586c1930c82b8e47554667a0cf786dc755af-2400x966.png) [{"_key":"4d1f356a2355","_type":"block","asset":null,"children":[{"_key":"9b2782694ae10","_type":"span","marks":[],"text":"Deflation can be good"}],"markDefs":[],"style":"h4"},{"_key":"3181f71d4f3a","_type":"block","asset":null,"children":[{"_key":"8ef4c3095a56","_type":"span","marks":["strong"],"text":"Demand-side deflation"},{"_key":"13f75886f4f6","_type":"span","marks":[],"text":" is often linked to "},{"_key":"9e99d77926c4","_type":"span","marks":["strong"],"text":"economic downturns"},{"_key":"4d4d5f69bee1","_type":"span","marks":[],"text":", "},{"_key":"f206da4b1a39","_type":"span","marks":["strong"],"text":"supply-side deflation"},{"_key":"662c8f74d8f4","_type":"span","marks":[],"text":" can be "},{"_key":"c6e039792f76","_type":"span","marks":["strong"],"text":"positive"},{"_key":"1d5835b6cd83","_type":"span","marks":[],"text":" for the economy:"}],"markDefs":[],"style":"normal"},{"_key":"6d4ae1f33e4d","_type":"block","asset":null,"children":[{"_key":"1530ec0c6c830","_type":"span","marks":["strong"],"text":"Supply-side deflation"},{"_key":"9a5eac2a805e","_type":"span","marks":[],"text":" can benefit the economy when caused by better technology or efficiency (such as computers becoming cheaper yet more powerful each year)."}],"level":1,"listItem":"number","markDefs":[],"style":"normal"},{"_key":"f780f323f746","_type":"block","asset":null,"children":[{"_key":"35bced9d6b900","_type":"span","marks":[],"text":"For consumers, their "},{"_key":"08317ac37f98","_type":"span","marks":["strong"],"text":"real income increases"},{"_key":"64afc3e76231","_type":"span","marks":[],"text":" as their money now buys more goods."}],"level":1,"listItem":"number","markDefs":[],"style":"normal"},{"_key":"63af57480a4e","_type":"block","asset":null,"children":[{"_key":"430403c2d3d5","_type":"span","marks":[],"text":"For the economy, "},{"_key":"d4105d072f63","_type":"span","marks":["strong"],"text":"production becomes more efficient"},{"_key":"254da6f0603c","_type":"span","marks":[],"text":", and output grows despite lower prices."}],"level":1,"listItem":"number","markDefs":[],"style":"normal"}] ### Disinflation and deflation [block_108] A slowdown in the rate of inflation, meaning prices are still rising but at a slower pace compared to previous periods. 1. **Deflation**, on the other hand, is a **sustained decrease in the general price level over time**. 2. While **deflation** is indicated by a **negative** **inflation** **rate**, **disinflation** can still result in a **positive inflation rate**. [{"_key":"block_114","_type":"block","asset":null,"children":[{"_key":"Ck70Ri4yn6Tjn6QD5bL1yk","_type":"span","markDefs":[],"marks":[],"text":"If inflation falls from 5% to 3%, this is "},{"_key":"d9b66d429ee2","_type":"span","markDefs":[],"marks":["strong"],"text":"disinflation"},{"_key":"bffa892d530a","_type":"span","markDefs":[],"marks":[],"text":"."}],"markDefs":[],"style":"normal"},{"_key":"f6ecb81175cd","_type":"block","asset":null,"children":[{"_key":"f5943df7cefb","_type":"span","markDefs":[],"marks":[],"text":"If inflation falls to -3% (negative), this is "},{"_key":"deb12fd5fea7","_type":"span","markDefs":[],"marks":["strong"],"text":"deflation"},{"_key":"07c26fb81d2f","_type":"span","markDefs":[],"marks":[],"text":"."}],"markDefs":[],"style":"normal"}] ## Costs of deflation [block_120] **Deflation** can create **serious problems** throughout the **economy**, particularly when caused by **falling demand**. Among these problems are: 1. **Deferred consumption and investment** 1. People and firms wait to buy because they expect lower prices tomorrow. 2. This waiting reduces current aggregate demand, forcing prices even lower. 3. This creates a self-reinforcing downward spiral of falling demand and prices. 2. **Policy ineffectiveness:** 1. Traditional monetary policy stops working at zero interest rates. 2. Price expectations (for future prices to decrease) become hard to change once deflation is expected. 3. This makes it very difficult for government to stimulate economy and stop deferred consumption. 3. **Association with high levels of cyclical unemployment and bankruptcies:** 1. Falling prices mean falling revenues for businesses. 2. Companies must cut costs, usually starting with workers, which raises unemployment. 4. **Increase in the real value of debt:** 1. Money owed becomes worth more in real terms over time 2. Fixed loan payments take a larger share of shrinking revenues, which makes it harder to service debts 5. **Uncertainty:** 1. Business planning becomes difficult. 2. Investment decisions are postponed. 3. Future revenue predictions become unreliable. 6. **Redistributive effects:** 1. Savers gain purchasing power unfairly while debtors suffer. 2. Workers with fixed wages gain while businesses struggle with costs. 7. **Inefficient resource allocation:** 1. Companies focus on survival rather than innovation. 2. Resources get spent on coping with deflation instead of productive investment. 3. Economic growth potential is wasted. [{"_key":"block_144","_type":"block","asset":null,"children":[{"_key":"Ck70Ri4yn6Tjn6QD5bL1zr","_type":"span","markDefs":[],"marks":[],"text":"How might cultural attitudes toward saving and spending influence the impact of deflation in different countries?"}],"markDefs":[],"style":"normal"}]