<LOW/STABLE INFLATION>

--SYLLABUS CONTENT--

--THINK AHEAD--

"If the inflation rate has fallen from 5% last year to 3% this year have prices dropped?", "is this considered inflation?"

--DEFINITIONS--

INFLATION

INFLATION refers to a PERSISTENT INCREASE in the GENERAL PRICE LEVEL over a period of time.

DISINFLATION

DISINFLATION refers to a DECREASE in the RATE (%𐤃) OF INFLATION, not a fall in the PRICE LEVEL.

DEFLATION

DEFLATION refers to a PERSISTENT DECREASE in the GENERAL PRICE LEVEL over a period of time

--RISE IN THE AVERAGE PRICE LEVEL--

A RISE in the GENERAL PRICE LEVEL occurs as long as the RATE OF INFLATION is a POSITIVE.

--RISE IN THE RATE OF INFLATION--

A RISE in the RATE OF INFLATION occurs when the RATE OF INFLATION INCREASES from the previous year.

--THINK AHEAD--

"If I told you the average price of goods in our economy went up last year, what exactly do you think I was measuring?" "Was it every single price, just a few, or something in between?" "How would you decide which prices to include and how much weight to give each one?" "If the price of coffee ☕ doubled, do you think it would have a bigger impact on me or on you?"

--MEASURING INFLATION: CPI--

--DEFINITION: CPI--

The CONSUMER PRICE INDEX (CPI) is a WEIGHTED PRICE INDEX that COMPARES THE TOTAL COST OF A BASKET OF CONSUMER GOODS & SERVICES that represents the ‘TYPICAL HOUSEHOLD’ IN ONE YEAR, WITH THE COST OF THE SAME BASKET IN A CHOSEN BASE YEAR. Changes in the CPI are intended to show how the COST OF LIVING for the AVERAGE HOUSEHOLD has changed over time.

--THINK AHEAD--

"The above articles all express price changes, and for this to make any sense, they all had to include a very important piece of information, which is????!",

--"WHAT IS A PRICE INDEX?"--

""

A PRICE INDEX refers to a series of numbers that express the level of a group of commodity prices relative to the level of the prices of the same commodities during an arbitrarily chosen base period and is used to indicate changes in the level of prices from one period to another.
The price of the commodities (basket) in the base year is given a value of 100, and the value of all other baskets are all expressed relative to this basket
Below are two inflation calculators. You can choose a base year and see how much, say, a $1 basket of goods in that year would be priced today and work out the % increase in price.

--(RWE) THE UK's CPI BASKET 2022--

--THINK AHEAD--

"Imagine the price of nappies increased by 200%, do you think this will have any impact on the price of your typical basket of shopping?"
"What about if the price of hair gel quadrupled? Do you think this will have any impact on the price of Mr. Bounous' typical basket of shopping?
"What about if the price of public transport trebled? Now this may well impact more people's baskets, given that we regularly use these services.

--"WHY IS IT WEIGHTED?"--

if we are to work out a SINGLE NUMBER to represent the AVERAGE PRICE RISE FOR ALL OF SOCIETY, then it makes sense to GIVE MORE IMPORTANCE or WEIGHT to price changes in goods/services (Such as public transport) that affects more of us, and GIVE LESS IMPORTANCE/WEIGHT to price changes in goods/services that only a few of us use (Such as nappies) right!
So how can we 'weight' price changes? Well importance is usually reflected in the amount of 'EXPENDITURE'; with a HIGH EXPENDITURE reflecting HIGH IMPORTANCE, and a LOW EXPENDITURE reflecting LOW IMPORTANCE, so we use the % of TOTAL EXPENDITURE of each good to determine its weight, then multiply the price change by this value.

--HOUSEHOLD EXPENDITURE SURVEY REQUEST--

Don't these weights change every year? Yes so surveys are sent out ANNUALLY so adjustments can be made. I was personally chosen to record my expenditure and help with the weighing adjustments for Singapore's CPI.

--CONSTRUCT THE CPI (HL)--

"Choose the content of the basket"

We can see from the spreadsheet above that the true basket contains hundreds of items, in this example we will only use three: Pizza, Baby formula, and MRT rides.

"Choose the base year prices to compare"

We will need to designate a particular year's basket value, as the base year to compare the values of other baskets. In this example, we have chosen the value of the 2009 basket.

"Insert the base year prices & quantities"

We insert the prices of each good in the base year and the quantities (These are held constant)

"Calculate the base year basket's value"

The value of the basket is not only based on the prices but also on the QUANTITY of each item bought. This is because the quantity bought REFLECTS THE LEVEL OF IMPORTANCE of each good IN TERM OF ITS IMPACT ON THE COST OF LIVING FOR THE AVERAGE HOUSEHOLD. Therefore any price changes in the most frequently bought items are given a higher weighting than price changes in less frequently bought items.
For example, baby formula is only purchased by households with young children, therefore any price changes in this item will only be given a small weighting whereas MRT rides are much more frequently bought, and therefore any price changes in this item will receive a higher weighting as it will more likely impact the cost of living of an average household.

"Calculate the other years' basket values"

Now we complete the table using the prices of each item in each year, using the same quantities.

"Convert the basket values into the CPI values"

Using the formula below we work out the CPI values for each year.

'CPI = (Value of basket in specific year / Value of basket in the base year) x 100'

PORTFOLIO CHECKPOINT

--Use the markscheme below to construct both 10-mark answers--

--THINK AHEAD--

"If after 3 years the basket's price has increased by 50% from the base year, and only 20% 2 years from the base year what was the inflation rate between year 2 and 3?"

--INFLATION & THE CPI--

--CALCULATING INFLATION USING THE CPI--

Now that the CPI is constructed we can work out the Inflation or deflation rates as the % change in the CPI values. A POSITIVE % CHANGE indicates INFLATION, whilst a NEGATIVE % CHANGE indicates DEFLATION.

PORTFOLIO CHECKPOINT

--Use the markscheme below to construct both 10-mark answers--

--THINK AHEAD--

--READ & DISCUSS--
"A 🍺 in 2023 costs a shocking $5, yet it only cost $1 back in 2003. That's a ('nominal') increase of 400% in the price! Disgraceful!"
"Hang on, you have to account for inflation. The price has risen, but the purchasing power of a dollar has fallen. A dollar in 2003 could buy a lot more than a dollar can today, right?"
"So you're saying the 400% increase doesn't accurately reflect the change in real purchasing power?"
"Possibly, let's check the CPI using 2003 as the base year (CPI = 100), and the 2023 value from this base year of 190. To find the 2023 price in 2003 dollars, we calculate (deflate): $5.00 * (100 / 190) ≈ $2.63. So, in terms of real purchasing power, the ('real') price has gone from $1.00 to about $2.63. That's a 163% real increase, not 500%."
"A 163% real increase is still huge! This is GREEDFLATION!"

FOOTBALL INFLATION

--ADJUSTING FOR INFLATION USING THE CPI--

EXAMPLE # 1:-

If Good X costs 50$ in the base year 100 (Year A), how much should the same good cost (in $ terms) in the basket with an index of 120 (Year B)?
- - - - That's easy, 100 to 120 is a rise of 20% so it should cost...
        120/100 * $50 = $60 (Price * 1.2)

EXAMPLE # 2:-

If Good X costs 50$ in the year with an index value of 110 (Year A), how much should the same good cost in the basket with an index of 120 (Year B)?
- - - - That's a bit trickier 110 to 120 is (120/110) = 1.09, so 9% more.
        (120/110) * $50 = $54.54 (Price * 1.09)

So the formula for adjusting prices using the CPI is:

FOOTBALL INFLATION

--LIMITATIONS WITH THE CPI--

--"ONE BASKET DOES NOT FIT ALL"--

"Apparently, as a coffee-loving nation the fact that the price of coffee beans has tripled means my cost of living has risen, despite the fact that I only ever drink tea!"
The CPI gives a single figure that represents the change in the cost of living for an AVERAGE household; however, as EACH HOUSEHOLD IS UNIQUE in terms of their respective consumer baskets, it cannot really be a truly accurate indicator of a family's changing cost of living.
For example, a rise in the price of Pork has little to no impact on the cost of living for a Muslim family, as it would for a non-muslim.

--SUBSTITUTION BIAS EXISTS--

"When the price of orange juice goes up, I am not moronic enough to keep on buying it in the same quantity; I just swap for a cheaper alternative, and my cost of living isn't impacted at all!"
In order to compare basket prices, the WEIGHTINGS NEED TO BE FIXED, however, IT IS NATURAL FOR CONSUMERS TO CHANGE THE QUANTITIES THEY BUY when the prices of individual items rise and fall. They will BUY LESS of those ITEMS WITH HIGHER PRICE CHANGES, thus reducing their weighting, and BUY MORE CLOSE SUBSTITUTES with relatively LOWER PRICE CHANGES increasing their weighting. However, since the weightings stay fixed for at least 24 months, the CPI will OVERSTATE the RISE in the COST OF LIVING.

--DISCOUNT OUTLET BIAS EXISTS--

"When the price of a single can of coke goes up, it doesn't really impact me, as I always 'buy in bulk' at the discount store, so it works out to less per can, so my cost of living isn't impacted at all!"
The PRICES used to compile the CPI, are usually BASED ON THE RETAIL RECOMMENDED PRICE (RRP) OF SINGULAR UNITS, however, this is not always the price that consumers pay due to the VAST NUMBER OF DISCOUNT STORES opening that sell individual units at lower prices in addition to BULK ORDERS which cost an even lower average price. Hence the CPI again OVERSTATES the true change in the cost of living.

--QUALITY BIAS EXISTS--

"According to the CPI, the price of 'mobile phones' has risen steadily; that's inflation, right?" "Hang on, my Nokia 3310 cost me $1000 back in 2000, and the same model is only $100 today. Also, I read that the ultra-function-heavy 2023 iPhone 15's base model is the same price as the much-more basic 2007 base model", "I'm seriously confused!"

QUALITY BIAS refers to a phenomenon in which the CPI CAN MISINTERPRET PRICE RISES DUE TO QUALITY ENHANCEMENTS AS INFLATION IN THE SAME PRODUCT. In other words, the CPI FAILS TO FULLY ADJUST FOR THE INCREASED VALUE OR UTILITY CONSUMERS DERIVE FROM NEW OR IMPROVED PRODUCTS. Hence, the CPI again OVERSTATES the true change in the cost of living.
Over time, products tend to improve in quality and in some cases become altogether new products. This can involve enhancements in durability, functionality, efficiency, or additional features.
For example, a newer model of a smartphone may have a (better) camera, longer battery life, or faster processing speed compared to its predecessor. However, if a product's quality improves over time but its price remains the same or increases only slightly, the CPI may inaccurately interpret this as inflation rather than an increase in quality.

--iPHONE EXAMPLE--

"If I told you the 2023 iPhone 15's base model is almost the same price as the 2007 base model, would you believe me?"

The first graph below shows how the price of iPhone's (Base, Pro, and Pro Max models) have changed over time using current (nominal) prices, suggesting that they have become more and more expensive, however if we look at the second graph which converts all prices into 2023 prices, we can see that the iPhone 15's base model is almost the same price as the 2007 base model.
In terms of utility to the consumer the iPhone 15 gives far more functionality and quality to the user than the 2007 model, however there has been an insignificant rise in the real price, which a CPI ignore and simply count the slight rise in price as inflationary, which seriously undervalues the utility gains. LINK

--NEW/REDUNDANT PRODUCTS--

"Apparently, the price of DVDs, stamps, and newspapers has doubled, how will I ever survive 😱?"
A further problem associated with having a FIXED BASKET of PRODUCTS and WEIGHTINGS, is that over time NEW PRODUCTS ENTER the consumption habits of a typical household, while EXISTING PRODUCTS BECOME STATISTICALLY INSIGNIFICANT, therefore if these changes are not captured by the CPI then it ignores the real impact of price changes.

--USELESS FOR INT'L COMPARISONS--

"My korean friend is very worried as apparantly the price of kimchi and soju has quadrupled, I can't see what all the fuss is about?"
We have already seen that due to numerous variables, consumer spending can differ from HOUSEHOLD to HOUSEHOLD and the basket's fixed content and weightings do not always accurately represent household expenditure. Given that baskets content and weighting differ from COUNTRY to COUNTRY, international comparisons are even more inaccurate.

-See the importance of onions to Indians.

--USELESS FOR COMPARISONS OVER TIME--

"When my grandpa was young, everyone ate spam and wore braces?"
Do you think the basket of the 1950s is the same basket as the 2020s? Of course not, the BASKET'S CONTENT & WEIGHTINGS ARE REVISED AT LEAST ONCE PER DECADE, as such comparisons of more than this length are less accurate.

PORTFOLIO CHECKPOINT

--Use the markscheme below to construct both 10-mark answers--

--CPI VARIATIONS--

--THINK AHEAD--

"When reporting your underlying performance do you think its fair to include how well you did in all this last minute Monday morning pop-quizzes, when you were tired, hungry, and super irritable?"

--CORE RATE OF INFLATION--

"When you include all the students grades, you get a?"
There are certain goods, notably FOOD and ENERGY products (such as oil) that have HIGHLY VOLATILE PRICES (meaning they fluctuate widely over short periods of time).
Reasons for price volatility include wide swings in supply or demand, causing large and abrupt price changes. When such goods are included in the CPI, they may give rise to misleading impressions regarding the rate of inflation. To deal with this problem, economists measure a CORE RATE OF INFLATION, which usually is done by constructing a CPI that does not include food and energy products with highly volatile prices.

--PRODUCER PRICE INDEX (PPI)--

The PRODUCER PRICE INDEX (PPI) measures the average change over time in the prices paid by domestic producers for their INPUTS. In most cases, A RISE IN THESE PRICES WILL BE REFLECTED IN A RISE IN THE CPI.
Input prices may rise for 2 reasons; either SUPPLY has been REDUCED or DEMAND has INCREASED.

PORTFOLIO CHECKPOINT

--Use the markscheme below to construct both 10-mark answers--

--THINK AHEAD--

"If you think back to the microeconomic models of supply and demand, what were the two causes of an increase in the price of a single good?"

--CAUSES OF INFLATION--

--DEMAND-PULL--

DEMAND-PULL INFLATION refers to a rise in the general price level caused by INCREASES IN AGGREGATE DEMAND (AD). It is associated with an INFLATIONARY GAP, so occurs at output levels greater than the full employment level of output.
DEMAND-PULL INFLATION results in HIGHER PRICES, HIGHER OUTPUT, and LOWER UNEMPLOYMENT in the SR.

--COST-PUSH--

COST-PUSH INFLATION refers to a rise in the general price level caused by INCREASES IN THE COSTS OF PRODUCTION OR SUPPLY-SIDE SHOCKS. It is associated with a FALL IN OUTPUT, as the SRAS CURVE SHIFTS LEFTWARDS. (Note, as the output gap ISN'T caused by a fall in AD it is not called referred to as a DEFLATIONARY GAP)
Because COST PUSH INFLATION results in HIGHER PRICES and LOWER OUTPUT & EMPLOYMENT, it is referred to as 'STAGFLATION' which is relatively worse than DEMAND-PULL inflation.
See PORKFLATION
See SHRINKFLATION
See TARIFFLATION, ARTICLE

CHECKPOINT

--Use the markscheme below to construct both 10-mark answers--

CHECKPOINT

--Use the markscheme below to construct both 10-mark answers--

--THINK AHEAD--

"Can you explain this headline?"

--COSTS OF INFLATION--

--REDISTRIBUTION EFFECTS--

--INFLATION & PURCHASING POWER--

NOMINAL INCOME refers to the dollar amount that a person receives, whilst their REAL INCOME refers to the quantity of goods and services that this money will buy. This of course is based on the current price levels, so if these PRICES RISE, the quantity of G&S that can be bought will FALL, in other words,
"The purchasing power of money will fall when price rise"

--"WHO WINS/LOSES FROM (UNEXPECTED) INFLATION?"--

💡TIP: To decide if the stakeholder is a winner or loser, simply consider whether the 'purchasing power' of their subsequent income or debt has risen or fallen in value.

--😞LOSERS--

--😜WINNERS--

-FIXED INCOME EARNERS-

If the APL RISES, and people's INCOMES REMAIN FIXED, then their REAL INCOMES will FALL, as the PURCHASING POWER OF THEIR INCOMES FALL. Therefore people on fixed incomes will be LOSERS.

-FIXED INCOME PAYERS-

If the APL RISES, and employees PAY FIXED WAGES, then their REAL LABOUR COSTS will FALL, Therefore Payers of fixed incomes will be WINNERS.

--LENDERS/SAVERS--

If the APL RISES, (by more than what was anticipated) then the REAL VALUE OF THE LENDER'S EXPECTED RETURN (interest plus principal) will have FALLEN in terms of its PURCHASING POWER Hence LENDERS are LOSERS.
If the APL UNEXPECTEDLY RISES, and SAVINGS are in a FIXED INTEREST ACCOUNT, then the REAL VALUE OF THE SAVINGS WILL FALL. Hence SAVERS will be LOSERS.

--BORROWERS--

If the APL RISES, (by more than what was anticipated) then the REAL VALUE OF THE BORROWER'S REPAYMENTS will have FALLEN in terms of its PURCHASING POWER Hence BORROWERS are WINNERS.

--DO NOW--

"Who are the two stakeholders here?"

"I am only willing to lend my hard-earned money to you for investment if I am 100% certain that the money you give me back in the future has a higher purchasing power than it does now."

"You are offering me 5% on my savings after a year, yet the last three years have seen the inflation rate fluctuate between 3% and 7%. Hmmm, I might as well spend it now!"

"Why is this situation a really big problem for an economy?" "If you had money, what would you do with it?"

--"Be prepared to share!!"--

--OTHER EFFECTS--

--IMPACT ON UNCERTAINTY--

"I am only willing to lend my hard-earned money to you for investment, if I am 100% certain that the money you give me back in the future has a higher purchasing power than it does now."

Unless the inflation rate is low and stable, it is VERY DIFFICULT FOR PEOPLE YOU PREDICT THE FUTURE REAL RETURNS of any transaction which involves payments at future dates. As shown above, it will DISCOURAGE SAVING AND LENDING ACTIVITIES and ultimately curtail investment and economic growth.

--IMPACT ON SAVINGS--

"You are offering me 5% on my savings after a year, yet the last three years have seen the inflation rate fluctuate between 3% and 7%, hmmm, I might as well spend it now!"

As we know inflation reduces the 'REWARD FOR SAVNG', thus LOWERING THE INCENTIVE TO SAVE and ENCOURGING MORE SPENDING NOW, which can add to inflationary pressure even more.

--IMPACT ON INT'L COMPETITIVENESS--

"Our prices are rising faster than theirs; no wonder everyone is ditching 'Made in HK' for 'Made in Vietnam', we are not only losing our competitive edge, but soon our jobs!"
If a country's inflation rate RISES RELATIVE to the rate in other countries then its EXPORTS will become UNCOMPETITIVE, resulting in EXPORT REVENUE FALLING and IMPORT EXPENDITURE RISING, which will LOWER NET EXPORTS.

--IMPACT ON ECONOMIC GROWTH--

UNCERTAINTY = LOW SAVINGS => LESS INVESTMENT so 'I' FALLS
LOSS OF INTERNATIONAL COMPETITIVENESS = LESS EXPORTS & MORE IMPORTS so 'NX' FALLS
Both 'I' and 'NX' are part of AD, so REAL GDP will FALL

--IMPACT ON EQUITY--

"Thankfully inflation hasn't really impacted me, as my property portfolio has actually increased in value, and also I have a lot of investments that are earning me higher returns than inflation. Phew, how about you?"
Inflation REDUCES THE PURCHASING POWER OF MONEY, and those with FIXED OR LOW INCOMES will inevitably suffer the most.
Not only are their incomes losing their real values but they LACK THE SAVINGS TO SAFEGUARD THEIR WEALTH through stock market investments or real estate, unlike high-income earners.

🌏REAL WORLD EXAMPLES🌏

PORTFOLIO CHECKPOINT

--Use the markscheme below to construct your answer(s)--

--THINK AHEAD--

"Hey everybody, I've got some great news: Labubu doll prices have fallen and will be falling next year and probably the year after that, what should we do?"

--DEFLATION--

--DEFINITION--

DEFLATION refers to a PERSISTENT DECREASE in the GENERAL PRICE LEVEL over a period of time.

--CAUSES OF DEFLATION--

--BAD DEFLATION--

DEFLATION that occurs due to a DECREASE IN AGGREGATE DEMAND is termed 'BAD DEFLATION' because the FALL IN THE GENERAL PRICE LEVEL is accompanied by a FALL IN REAL GDP, causing a recession.

--GOOD DEFLATION--

DEFLATION that ocurs due to an INCREASE IN AGGREGATE SUPPLY is termed 'GOOD DEFLATION' because the FALL IN THE GENERAL PRICE LEVEL is accompanied by a RISE IN REAL GDP, causing economic growth.

--WHY GOOD DEFLATION IS STILL BAD--

When prices keep falling, people tend to POSTPONE THEIR PURCHASES in the expectation that prices will fall further; however, this fall in economic activity means...

--WHY DEFLATION IS RARE--

Deflation is not a common phenomenon. Whereas it is often the case that the price of a particular good or service may fall over time, it is rare to see the general price level of an economy falling. There are several factors that account for this:

WAGES DO NOT ORDINARILY FALL: This means it is difficult for firms to lower the prices of their products, as this would cut into their profits, especially since wages represent a large proportion of firms’ costs of production. There are several reasons why wages do not fall easily (labour contracts, minimum wage legislation, worker and union resistance to wage cuts, ideas of fairness, fears of negative impacts on workers’ morale, etc.).
LARGE OLIGOPIOLISTIC FIRMS MAY FEAR PRICE WARS: If one firm lowers its price, then others may lower theirs more aggressively in an effort to capture market shares, and then all the firms will be worse off. Therefore, firms avoid cutting their prices.
AVOID MENU COSTS: Firms want to avoid incurring menu costs resulting from price changes, particularly if they believe that the lower prices will prevail only for short periods of time. Therefore, they avoid lowering their prices.

--COSTS OF DEFLATION--

--REDISTRIBUTION EFFECTS--

--😞LOSERS--

--😜WINNERS--

--FIXED INCOME PAYERS--

If the APL FALLS, and employees PAY FIXED WAGES, then their REAL LABOUR COSTS will RISE, Therefore Payers of fixed incomes will be LOSERS.

--FIXED INCOME EARNERS--

If the APL FALLS, and people's INCOMES REMAIN FIXED, then their REAL INCOMES will RISE, as the PURCHASING POWER OF THEIR INCOMES RISE. Therefore people on fixed incomes will be WINNERS.

--BORROWERS--

If the APL FALLS, (by more than what was anticipated) then the REAL VALUE OF THE BORROWER'S REPAYMENTS will have RISEN in terms of its PURCHASING POWER Hence BORROWERS are LOSERS.

--LENDERS--

If the APL FALLS, (by more than what was anticipated) then the REAL VALUE OF THE LENDER'S EXPECTED RETURN (interest plus principal) will have RISEN in terms of its PURCHASING POWER Hence LENDERS are WINNERS.

--OTHER EFFECTS--

--IMPACT ON THE VALUE OF DEBT--

"I borrowed a lot of money, and now that prices have fallen, the real value of my repayments has risen."
As already mentioned, in the LOSERS section, those who have debt (borrowers) will see the REAL VALUE OF DEBTS INCREASE => LESS CONSUMER SPENDING.

--IMPACT ON INVESTMENT SPENDING--

"I borrowed a lot of money, and now that prices have fallen, the real value of my repayments has risen."
Deflation also DISCOURAGES BORROWING by both consumers and firms, as the REAL VALUE OF DEBT INCREASES as the price level falls. The result is that business spending ('I') falls, causing aggregate demand to fall. If the economy is already in recession, this will become deeper with falling AD, unemployment increases further, incomes and prices fall further, deflationary pressures increase further, spending and borrowing decrease further, and so on in a downward spiral.

--IMPACT ON CONSUMPTION SPENDING--

Deflation DISCOURAGES SPENDING by consumers because they POSTPONE MAKING PURCHASES as they expect that prices will continue to fall, thus REDUCING 'C' and AD, creating cyclical unemployment.

--IMPACT ON BANKRUPTCIES--

As mentioned, the VALUE OF DEBT INCREASES, which when coupled with FALLING SALES often results in businesses being UNABLE TO AFFORD REPAYMENTS and defaulting on their loans resulting in them going bankrupt.

--IMPACT ON RESOURCE ALLOCATION--

--INEFFECTIVENESS OF POLICY--

--POSITIVE IMPACT OF DEFLATION?--

Increases their purchasing power, allowing them to save more money as their income increases relative to their expenses.

PORTFOLIO CHECKPOINT

--Use the markscheme below to construct both 10-mark answers--

🌏REAL WORLD EXAMPLES🌏

PORTFOLIO CHECKPOINT

--Use the markscheme(s) below to construct answer(s)--

--UNEMPLOYMENT vs INFLATION--

--THE PHILLIPS CURVE 'TRADE OFF' (HL)--

Studying UK data from 1861-1957, it was observed by the New Zealand Economist William Phillips, that there appeared to be a STABLE TRADE OFF BETWEEN WAGE RATE INCREASES and LEVELS OF UNEMPLOYMENT as shown here:

This data suggested the following:

UNEMPLOYMENT RATE ↓ when NOMINAL WAGE↑
UNEMPLOYMENT RATE ↑ when NOMINAL WAGE↓

Given the strong positive relationship between wage growth and higher general prices (firm's pass the higher labour costs on to customers) the relationship was further developed to reflect inflation as follows:
- - UNEMPLOYMENT RATE ↓ leads to AV. PRICE LEVEL↑
  - UNEMPLOYMENT RATE ↑ leads to AV. PRICE LEVEL↓
So it would appear from this that LOW INFLATION + LOW UNEMPLOYMENT were IN CONFLICT, in other words governmnets would have to TRADE-OFF one objective for the other.

--THE PHILLIPS CURVE & THE AD/AS--

The Phillips curve is almost the mirror image of the AD-AS diagram.
Clearly the level of employment (and hence unemployment) is linked to the level of Real GDP. The greater the level of GDP the lower the level of unemployment and vice versa.

--WAS THE PHILLIPS CURVE CORRECT?--

IN THE SHORT-RUN 'YES':
- - - DEMAND RISES => DEMAND FOR WORKERS INCREASES => HIGHER NOMINAL WAGES BEING PAID => AS WAGES RISES => COSTS OF PRODUCTION RISE => AVERAGE PRICE LEVELS START TO RISE (INFLATION) => NOMINAL WAGE INCREASE IS MISTAKEN FOR REAL INCREASE IN WAGES SO MORE PERCEIVED INCENTIVE TO WORK ('MONEY ILLUSION') => UNEMPLOYMENT FALLS.

IN THE LONG-RUN 'NO':

- - - AS AVERAGE PRICE LEVELS RISE (INFLATION) => RECOGNITION THAT REAL WAGE HAS RETURNED TO ORIGINAL LEVEL => EXTRA INCENTIVE TO WORK DISAPPEARS => UNEMPLOYMENT RETURNS TO NATURAL RATE.
SO WE CAN SEE IN THE LONG RUN, THERE IS 'NO TRADE-OFF'
Previously we learned that in the long run, factor prices will readjust and the economy WILL ALWAYS RETURN TO THE NATURAL RATE OF UNEMPLOYMENT, so what does this mean for the Phillips curve?
If we mapped this readjustment following an inflationary gap on the AD/AS model onto the Phillips curve we can see the following.
The LRPC rests at the NRU in this case at 5%
So we can conclude that the TRADE-OFF of lower unemployment and higher inflation during an inflationary gap IS TEMPORARY and will always end up impacting the price level only (Pl1 to Pl2).

--REAL WORLD EXAMPLES--

✅ 1. Post–World War II Boom (Late 1940s–1950s, USA & UK): Unemployment: Very low due to high demand, rebuilding, and wartime savings being spent. Inflation: Rose sharply because firms couldn’t keep up with surging demand. Why it shows the trade-off: Governments tolerated higher inflation to maintain full employment.

✅ 2. 1960s United States – “Golden Era” of the Phillips Curve: Under Presidents Kennedy and Johnson. Unemployment: Fell to around 3–4%, the lowest in decades. Inflation: Increased gradually from 1–5%. Policymakers explicitly used the Phillips Curve to justify tolerating more inflation in exchange for jobs.

✅ 3. 1970s UK (Before Stagflation) Early 1970s, before the oil crisis. Unemployment: Dropped to 2–3%. Inflation: Climbed to 9–15%. The UK government pumped spending into the economy to preserve jobs, causing inflation to spike.

✅ 4. Post–2008 Financial Crisis Stimulus (2010–2019). USA, UK, and Europe used loose monetary policy (low interest rates & QE) to cut unemployment. Unemployment: Fell from 10% → 4% (USA). Inflation: Gradually picked up from near zero to 2%. Central banks accepted inflationary pressure to reduce unemployment.

✅ 5. Japan in the 2010s (Abenomics). Japan had persistent deflation and high unemployment concerns. The government deliberately created moderate inflation (2% target) through stimulus. Result: Unemployment fell from 4.5% → 2.5%, Inflation rose from 0% → 1–2%. A textbook example of sacrificing price stability for jobs.

✅ 6. Post-COVID Reopening (2021–2022, USA & Europe): Unemployment: Fell rapidly as economies reopened. Inflation: Jumped to multi-decade highs (6–10%). Huge fiscal stimulus, low interest rates, and labour shortages all combined to show the trade-off in real time.

--THE BREAKDOWN OF THE PHILLIPS CURVE--

WE CAN SEE THAT THIS RELATIONSHIP IS SOLELY BASED ON THE IDEA THAT CONTROLLING AGGREGATE DEMAND WILL DETERMINE INFLATION AND UNEMPLOYMENT RATES.
HOWEVER, AS WE KNOW CHANGES IN AGGREGATE SUPPLY ALSO IMPACT PRICES AND EMPLOYMENT LEVELS.
IN THE 1970s & 1980s, 'SUPPLY-SIDE SHOCKS', INVOLVING OIL AND FOOD PRICES INCREASED COSTS OF PRODUCTION, WHICH AS WE KNOW SHIFT THE SUPPLY CURVE TO THE LEFT.

SRAS ↓ => UNEMPLOYMENT RATE ↑ => AVERAGE PRICE LEVEL (APL) ↑
WHEN BOTH RATES RISE TOGETHER IT IS CALLED 'STAGFLATION'

--REAL WORLD EXAMPLES--

❌ ✅ TRUE BREAKDOWNS of the Phillips Curve

These are the real contradictions — where inflation and unemployment moved in the same direction or didn’t respond as expected:

❌ 1. 1970s Stagflation

Inflation ↑

Unemployment ↑

✅ Clear breakdown due to supply shock (oil crisis).

❌ 2. Japan’s Lost Decades (1990s–2000s)

Low/negative inflation

Unemployment didn’t fall much

✅ Demand trap, deflation expectations, wage rigidity.

❌ 3. 2015–2019 USA/UK

Unemployment very low

Inflation stayed low

✅ Globalisation, weak unions, technology reducing wage pressure.

These are the true Phillips Curve failures.

PORTFOLIO CHECKPOINT

--Use the markscheme below to construct both 10-mark answers--

--PAST PAPERS--

--PAPER 1 (HL)--

--10-MARKER--

--15-MARKER--

Using real-world examples, examine the view that there is a possible trade-off between unemployment and inflation.
Discuss the view that deflation is more harmful than inflation.
Using the monetarist/new classical model and the Keynesian model, discuss the view that increases in aggregate demand will inevitably be inflationary.
NOTE: The majority of 15 markers that are related to achieving economic objectives, such as low and stable inflation, focus on evaluating the policy responses e.g "Evaluate the effectiveness of interventionist supply-side policies in reducing demand-pull inflation.", so will be inlcuded later.

--PAPER 1 (SL)

10-MARKER

15-MARKER

NOTE: The majority of 15 markers that are related to achieving economic objectives, such as low and stable inflation, focus on evaluating the policy responses e.g "Evaluate the effectiveness of interventionist supply-side policies in reducing demand-pull inflation.", so will be inlcuded later.

--PAPER 2 (HL/SL)--

--PAPER 3 (HL ONLY)--

https://time.com/6221771/stagflation-crisis-debt-nouriel-roubini/

LEGO GREEDFLATION HERE