Deflation and Inflation Cost-push and Demand-push Q3

Q.
(a) Explain the difference between deflation and inflation. (4 marks)

(b) Explain two (2) of the following factors as causes of inflation.

(i) Cost-push inflation (4 marks)

(ii) Demand-pull inflation (4 marks)

(c) Describe the following two (2) methods to tackle inflation.

(i) Monetory Policy (4 marks)

(ii) Fiscal Policy (4 marks)

(20 marks, 2015 Q3)

(18.09.2015)
A.
(a) Differences between deflation and inflation, please see earlier posts below:

2012 Q6 - differentiate the meaning of inflation and deflation.
2012 Q6b - which is worse?

(b) Causes of inflation

(i) Cost-push inflation -

From Wikipedia, Cost-push inflation is an alleged type of inflation caused by substantial increases in the cost of important goods or services where no suitable alternative is available.

A situation that has been often cited of this was the oil crisis of the 1970s, which some economists see as a major cause of the inflation experienced in the Western world in that decade. It is argued that this inflation resulted from increases in the cost of petroleum imposed by the member states of OPEC. Since petroleum is so important to industrialised economies, a large increase in its price can lead to the increase in the price of most products, raising the inflation rate. This can raise the normal or built-in inflation rate, reflecting adaptive expectations and the price/wage spiral, so that a supply shock can have persistent effects.

Keynesians argue that in a modern industrial economy, many prices are sticky downward or downward inflexible, so that instead of prices for non-oil-related goods falling in this story, a supply shock would cause a recession, i.e., rising unemployment and falling gross domestic product. It is the costs of such a recession that likely causes governments and central banks to allow a supply shock to result in inflation. They also note that though there was no deflation in the 1980s, there was a definite fall in the inflation rate during this period. Actual deflation was prevented because supply shocks are not the only cause of inflation; in terms of the modern triangle model of inflation, supply-driven deflation was counteracted by demand-pull inflation and built-in inflation resulting from adaptive expectations and the price/wage spiral.

(ii) Demand-pull inflation -

From Wikipedia, Demand-pull inflation is asserted to arise when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as "too much money chasing too few goods".[1]More accurately, it should be described as involving "too much money spent chasing too few goods", since only money that is spent on goods and services can cause inflation. This would not be expected to happen, unless the economy is already at a full employment level.

(c) Tackle inflation

(i) Monetory policy

Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.[1][2][3]

Further goals of a monetary policy are usually to contribute to economic growth and stability, to lower unemployment, and to maintain predictable exchange rates with other currencies.

Monetary economics provides insight into how to craft optimal monetary policy.

Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values.

Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.[4]