Inflation is a persistent rise in the general price level of goods and services The value of money is eroded and it takes more money to buy the same items – NOT because there is a change in the market price due to a change in D or S or because of a price rise in an individual market!

Situation where the rate of inflation is falling, but is still positive. Where the general level of prices are falling, increasing the value of money. It is a situation of deflation where the rate of inflation has fallen to a negative rate Deflation can be considered to be worse than inflation. This is because when the value of money is appreciating, consumers may delay purchases hoping that prices will fall, causing a fall in Aggregate Demand, meaning a possible downward spiral in the level of economic activity (as seen during the “Great Depression in the 1930’s)

Functions of money Store of value Medium of Exchange Means of Deferred payment Measure of value During very high periods of inflation, money ceases to be a store of value, and is an ineffective means of deferred payment Money is still useful for immediate purposes – buying things and deciding which of the alternatives available offers the best value of money.

Aim of Reserve Bank: achieving “stability in the general price level” using the monetary policy. Price stability defined in PTA as “1 to 3 percent on average over the medium term, defined in terms of the All Groups Consumers Price Index (CPI), as published by Statistics NZ” Because of the negative effects of Deflation, a level of inflation is desirable – but high rates in inflation can also be devastating. This is why the official definition of price stability requires there to be a lower as well as upper limit to the level of inflation.

A theory used to explain the relationship between the money supply and the price level (rate of inflation) Money Supply Velocity of Circulation (the speed at which money circulates or changes hands in the economy) Price Level Quantity of goods produced, ie GDP Crude Theory: if Q and V are held constant, an increase in M leads to more aggregate demand and a shift in the aggregate demand curve to the right, which means an increase in P (inflation) – shows the importance of the money supply being controlled. Sophisticated Theory: If just V is held constant, an increase in M could mean either a rise in in P or Q, or both (an increase in P is inflation, an increase in Q is growth) Q may be relatively constant at the top of the business cycle because the economy is near full capacity or that resources are almost fully employed and real output (Q) cannot expand further.

M1: notes and coins + cheque accounts and EFTPOS M3: includes M1 and all other deposits (term investments) Influences on money supply: RB official cash rate – affects amount of lending available lending: if banks lend more that they have in deposits = inc money supply government’s budget deficit Reserves banks open market operation: buys more gov sec, stocks, bonds from public than it sells = inc in money supply As money is used as a means of paying for g & s, the more money there is available, the more likely that inflation will occur. Demand-pull inflation Q P Increase in demand

Inflation caused by increases in the cost of production, leading to a rise in the general price level as producers attempt to cover their increased expenses. The increased costs have lead to a reduction in aggregate supply, shown by a shift of AS to the left, leading to a rise in prices (inflation) AS is made up of nominal wages, import prices, and productivity. Reasons Increases in Wages (a cost Of production) Rise in cost Of other Production Inputs E.g. oil Reduced productivity & Efficiency inc costs of Production (may happen Because of old machinery Or management systems) Higher Import costs (where imports Are production Inputs)

Is a rise in the general price level that is caused by an excess of aggregate demand over aggregate supply. An increase in demand in the economy as a whole leads to a shift in the demand curve to the right, from D – D1, and so there is a rise in the price level. AD is made up of consumption/household spending, government spending, investment spending, or net exports change. Reasons An increase in Consumers income (may be result of lower Income taxes or inc in Wages) More spending by the govt (on health, Education, etc) More investment By business – More spending on Capital goods = More Ag demand Increase in income From exports. Leads to more Income at home And greater Ag demand Fewer imports & More domestic Goods purchased More credit av & lower int rates Encouraging cons And businesses To borrow & spend

Gov made less credit available – to discourage consumer spending & business investment Reduced its own spending Allowed more imports into the country – so Aggregate demand for domestic goods reduced Deregulated labour market in 1987 – employers were able to resist or heavily reduce demand for wage increases Many businesses reduced labour input & raises productivity Restrictions on imports lowered & producers could take adv. of lower import costs

A price you pay for using other people’s savings. The price is determined by the supply of savings in the economy and the demand for savings from people wanting to borrow. When there is inflation, there is a negative effect on savers because inflation decreases the real value of savings. Borrowers gain when inflation is high because of the decrease in real value of the amount borrowed. Therefore: Savers want a high interest rate for their money – if they think inflation will rise they want to increase interest rates to protect their return Borrowers want to pay as low a rate as possible If interest rates rise, production costs can rise – leading to cost-push inflation The economic aim is to have low inflation, low interest rates and steady growth – but sometimes the RB is happy to have interest rates rise to an extent that will discourage excessive borrowing in the financial markets, which may in turn lead to higher CPI inflation in the short term.

Total Production Levels Years Recession Boom Economic or business activity in an economy is not consistent. Some periods there may be a boom and others a recession, which over time are experienced in a cycle. A boom occurs in an economy when: aggregate demand increases total production of g & s increases employment levels increase A recession occurs when: aggregate demand decreases total production of g & s decreases employment levels decreases Economy’s capacity to supply g & s sustainably over time Actual output over time When the line is above the Economy’s capacity… aggregate demand is decreasing and the actual production levels within the economy are exceeding the capacity to supply goods and services on a sustainable basis. This will lead to shortages of resources and price increases which will stimulate cost push inflation.

Cause Domestic Budget Deficit can Increase Aggregate demand Or financing debt can increase Money supply If a DB surplus leads to Tax cuts – inc Aggregate demand And therefore dp inflation Inflationary expectations Exchange Rates Terms of trade - Overseas Prices Productivity Inflation

Costs Changes in input prices Inflation pushes up the prices of inputs (raw materials, services Labour). May change type of inputs or have no choice but to pay higher prices Less certainty in planning ahead: frequent price changes can make it difficult for a firm to plan ahead and to make Production and Sales decisions. Prices of inputs influences what to produce, how much, and to which markets Raising prices to recover Cost increases: Because cost increases reduce profit (revenue), firms may increase the prices of g&s that they sell – they may have no option. The increase input prices may shift the supply curve to the left meaning the firm supplies less and charges more. Q P

Business Investment Loss of business confidence Firms aim to make a profit – and if sales are going well, may decide to expand, investing in productive assets (machinery, etc). If inflation is high it is hard to know if profits will increase at same rate as costs, as costs are constantly changing. Investment High inflation can make long-term investment plans difficult, and this lack of confidence may mean a firm decides to invest in non-productive areas such as property or shares. Lack of efficiency A firm may pass on cost increases to others by increasing own prices, or absorb increases by being more efficient (through investment in mach, tech) If the first option is chosen the firm has no incentive to increase efficiency.

a certain amount of money buys fewer goods/consumers have to pay more for g&s reduction in spending power and fall in standard of living To compensate, consumers want increased income (wages, salaries, interest on s) Even when incomes rise with inflation there are problems: some people find it easier to increase incomes, fixed incomes, increases in income are taxed, time lags. Saving: not spending now and instead putting away in bank acc, etc Inflation erodes value of savings Encourages people to have more non- money assets (e.g. property, paintings that may inc in value to make up for inflation) High inflation encourages people to spend rather than save Savers unable to protect the value of money assets Want higher interest rates to protect Real interest rate = nominal int rate – inflation rate

Resources will be able to be allocated more efficiently. Menu costs are minimised. Able to plan for the future with more confidence More inclined to invest to increase productive capacity if price signals are reliable. This leads to economic growth increasing. Exports are more likely to remain competitive. Interest rates are unlikely to suddenly change. Exchange rate is more likely to remain stable / steady. Costs and prices are more certain. certainty over prices (consumer confidence increases) less need for wage increases retained standard of living (fixed income earners) savings protected (get a real return) mortgage interest rates lower

If the prices of our goods rise more quickly than those of trading partners, there will be a negative impact on trade: higher prices for exports makes it harder for NZ products and services to compete on international markets higher prices at home can lead to more imports coming into NZ, because the imported goods are cheaper i.e. fewer exports, more imports = bop difficulties Trade important part of NZ economy to keep inflation low, RB wants the exchange rate within a range of values as measured by TWI

GDP = C + I + G + (X-M) High inflation can have a negative effect on growth because of the negative effect that it has on trade and investment Trade: loss of competitiveness (less exports) and cheaper imports Investment: loss of business confidence Invest in share market, land and buildings, rather than in machinery and technology which lead to more production = growth businesses are not encouraged to be more efficient as they can rely on price increases to make up for inefficiencies.

Use specific terms such as revenue, income, profit instead of the term money Use a dotted line for equilibrium Use correct terms for the people involved (the govt, rb, dairy farmers) For changes in equilibrium use the term aggregate demand, not demand Follow instructions e.g. Refer to the resource