Inflation

— Economics · AS Level (Online Batch MJJ 2026) —

★ Exam Tip: This chapter ends with Evaluation — for every effect and policy, be ready to say who is hurt more and what it depends on (anticipated vs unanticipated, internal vs external, type of exchange-rate system).

1. What is Inflation? & Aggregate Demand

Inflation → Prices ↑

Definition: a persistent and sustained increase in the general price level over a given period of time.

★ Aggregate Demand (AD)

Definition: the total demand of the whole economy e.g. the Pakistan economy.

AD = C + I + G + (X − M)

Where: C = consumption | I = investment | G = govt. expenditure | X = exports | M = imports

Board arrows over AD: AD ↑ when C ↑, I ↑, G ↑, X ↑ but M ↓ (imports are subtracted).

Example:

AD = C + I + G + (X − M)AD = 100 + 100 + 100 + (300 − 100)AD = $500

Balance of Trade (BOT) = X − M

BOT = XTR − MTE
(export revenue − import expenditure)

BOT surplus → XTR > MTE
BOT deficit → MTE > XTR

The 5 components — how each one raises AD

1) Consumption expenditure — done by consumers, generates income, affects AD!!

Situation: Recession → income ↓. Policy: Income tax ↓ → disposable income ↑ → purchasing power ↑ → consumption ↑ → AD ↑

2) Investment expenditure — done by producers/firms, generates income, affects AD!!

Yr 1: interest rate 20% → Yr 2: interest rate 10% (r ↓). Then two groups react:

Savers	Borrowers
save ↓ (rate of return ↓)	borrow ↑ (cost of borrowing ↓)
spend ↑ → C ↑	reinvestment ↑ → I ↑
AD ↑	AD ↑

3) Government expenditure — done by government, generates income, affects AD!!

Roads ↑ → Jobs ↑ → Income ↑ → C ↑ → AD ↑

4) Export revenue (XTR) — Policy: subsidy to domestic producers

X price ↓ → X qty ↑ → XTR ↑ → C ↑ → AD ↑

5) Import expenditure (MTE) — Policy: tariff (tax on imported goods)

M price ↑ → M qty ↓ → MTE ↓ → people switch to domestic goods → C ↑ → AD ↑

Circled on board: XTR > MTE = surplus · BOT = XTR − MTE · MTE > XTR = deficit

2. Effects of Inflation (#1 – #9)

#1 Unemployment (internal effect)

Inflation → Prices ↑ → Consumption ↓ → AD ↓ → producer gets the signal → production ↓ → demand for labour (DL) ↓ → Unemployment ↑

Producer contracts production and, to maintain profits, lays off some employees.

#2 Balance of Trade deficit (external effect)

Pakistan has inflation

Inflation → Prices ↑

Exports: X price ↑ → X qty ↓ → XTR ↓

Relatively (for residents) imports look cheaper: M price ↓ → M qty ↑ → MTE ↑

MTE > XTR ⇒ BOT deficit

Our goods become uncompetitive in the international market. Considering export and import demand are elastic, export revenue falls and import expenditure rises.

#3 Depreciation of the currency (FOREX market)

Exports side (Pakistan → USA)	Imports side (USA → Pakistan)
payments received ↓	payments made ↑
demand for Rs ↓	sell / supply of Rs ↑
surplus of Rs	surplus of Rs
value of Rs ↓	value of Rs ↓

⇒ Depreciation — other countries buy less of our goods so they demand less of our currency; more import expenditure means more of our currency is sold. Both push the value of Rs down.

#4 Effect on Real Income

RI % = Nominal Income % − Inflation %

Nominal income → before deduction of tax and inflation rate
Disposable income → after deduction of tax
Real income → after deduction of tax and inflation rate

Tax stepNI = 100,000tax = 100,000 × 10% = $10,000D.I. = 100,000 − 10,000 = $90,000

Then inflationIR% = 10%, 15%, 18%, 20% …RI% = NI% − IR%100,000 − 10% → …100,000 − 20% → RI Nil

Remember: at times of inflation your real income starts to fall (RI ↓ ⇒ purchasing power ↓). If nominal income > inflation you are still better off in real terms. Workers go to the trade union to push the employer to raise wages in line with inflation — or they will be worse off.

#5 Effect on Savers

Real interest rate % = Nominal interest rate % − Inflation rate %

RIR = nominal − inflationRIR = 20% − 30%RIR = −10% (RIR ↓)

Day 1: save $100,000 at 20% ⇒ $120,000 after a year. Day 365: inflation turns out to be 30% ⇒ money buys less than before.

Bank interest rate (BIR) vs inflation (IR%): BIR > IR% ⇒ savings protected · IR% > BIR% ⇒ savers lose

At times of inflation saving is discouraged.

#6 Lenders / Borrowers · #7 Menu cost

#6 Lenders & borrowers: it is easier for a borrower to repay during inflation, but when the lender gets the money back it is worth less. Lenders therefore set the interest rate according to the (expected) inflation rate.

Board example: Day 1 inflation expected 5% → loan $100,000 at 10% ⇒ $110,000 back; Day 365 inflation is 20% ⇒ lender loses in real terms.

#7 Menu cost: the price list (e.g. a restaurant menu) must be changed again and again.

Weekly price ↑ (burgers) → input price/cost ↑ → price ↑ → menus must be reprinted → printing cost (menu cost) ↑ → further raises price, at a faster rate.

#8 Shoe-leather cost · #9 Pension / fixed-income earners

#8 Shoe-leather cost: people have to move around (and at different times) to gather savings/investments and re-invest them in line with inflation — this takes time, and meanwhile the value of money keeps falling.

#9 Pension / fixed-income earners: the worst hit — prices rise at a faster rate, purchasing power falls and their (fixed) income is substantially curtailed.

★ Conclusion of Inflation → Evaluation

① Anticipated vs Unanticipated rate: if an economy can predict inflation with accuracy, the effects are less harmful than when inflation is unanticipated.

② Internal vs External effects — which is more harmful?
• Economy open to international trade (income depends on the foreign sector) → external effects hit harder: BOT deficit + depreciation.
• Economy not open (income depends on the domestic sector) → internal effects (unemployment, falling real income…) are more harmful.

③ Which type of exchange-rate system? A free-floating (freely fluctuating) system leaves the economy unstable when inflation occurs; under a fixed or managed-floating system the government keeps intervening to stabilise the economy.

Teacher's live demo: AED → USD on Google stayed ≈ 0.27 $ (3.67 AED = 1 $) on 1D, 5D, 1M, 1Y, 5Y charts = fixed/pegged. The Pakistan open-market FOREX sheet (7/1/2026) showed rates moving: US $ 280.75 buy / 282.8 sell, UAE Dirham 76.55 / 77.55, Euro 327.75 / 331.5.

So: the AED barely moves (managed/pegged) while the Rs is market-driven ⇒ a floating currency feels inflation more.

3. Causes of Inflation — Cost-Push & Monetary

Note: the board numbers the causes 1) demand-pull, 2) cost-push, 3) monetary. The demand-pull page is not in the uploaded file, so only the AD ↑ → shortage → prices ↑ chain (see section 4) is covered.

2) Cost-Push Inflation → reason: AS ↓

Cost ↑ → burden ↑ → derivative AS ↓ → shortage → Prices ↑ → Inflation

Reasons (cost ↑):

Cost of production ↑
Imposition of indirect tax
Removal of subsidy
Price of raw materials ↑
Imported inflation
Wage-price spiral

SRAS → SRAS₁ (left): P ↑, Y ↓

A decrease in short-run AS from SRAS to SRAS₁ (cost of production ↑) creates a shortage, so the price level rises from P to P₁ (the inflation rate).

Real income falls from Y to Y₁ ⇒ purchasing power ↓. New equilibrium moves e → e₁.

Wage-Price Spiral

Trade union: an organisation of working people who agree to negotiate with the employer on behalf of employees.

Employee — Trade Union — Employer

spiral never ends: wages ↑ ↔ productivity

Employee	Employer
Reason: inflation → prices ↑ Target: wages ↑	Reason: inflation → P↑ (productivity asked in return) Condition: wages ↑ ⇒ productivity ↑

Board conclusion: wages and productivity can never be matched ✗ — a rise in wages is not matched by a rise in productivity, so cost of production ↑ → AS ↓ → shortage → prices ↑ (cost-push) and the cycle repeats until productivity catches up.

On the other side, higher wages = higher worker income = purchasing power ↑ → demand ↑ → shortage → prices ↑ ⇒ demand-pull inflation too.
If the trade union teams up with the government to push wages up, unemployment follows: higher wages raise cost of production, more labour is supplied but less is demanded.

Imported Inflation

USA has inflation, Pakistan imports (oil)

PED of oil: short run → inelastic, long run → elastic.

M price ↑ 50% → M qty ↓ only 10% → MTE ↑ → cost ↑ → AS ↓ → shortage → price ↑ → imported inflation

Imported inflation occurs when an economy imports raw material (inelastic in the short run) from a country that faces inflation — we cannot cut quantity much, so import expenditure rises and so does our cost of production.

For the exporting country (USA): X price ↑ → X qty ↓ → XTR ↓.

3) Monetary Inflation → reason: Money Supply ↑

Banking background: Money → money demand (spending, saving, investment purposes) and money supply (central bank, objective: price stability ⇒ stable money supply ⇒ vertical curve). Banks → commercial banks (deal with customers; shareholder-owned, profit maximisation) and the central bank (deals with commercial banks; under government, price stability). Central bank → monetary policy → interest rate.

Two relations (circled): M.S and r → −ve · r and ER → +ve

Money demand: every transaction has an opportunity cost — the money could have been saved and earned interest. So interest rate and quantity demanded of money are negatively related ⇒ downward-sloping MD.

Monetary equilibrium: intersection of money demand and money supply decides the interest rate and quantity of money.

MS → MS₁: r ↓ to r₁

AD₁ → AD₅: mild → hyper-inflation

Money supply ↑ and interest rate ↓ (−ve):

Savers	Borrowers
save ↓ (rate of return ↓)	borrow ↑ (cost of borrowing ↓)
spend ↑ → C ↑	reinvestment ↑ → I.E. ↑
AD ↑	AD ↑

producer: production ↑ → DL ↑ → Unemployment ↓

Short run	Long run
Multiplier effect (income, output, employment ↑) → mild inflation: prices ↑ 10%, R.I. ↑ 50% (prices rise slower than real income)	Hyper-inflation: only price level ↑, R.I. constant (–)

Exchange-rate route (r ↓ ⇒ ER ↓, +ve):

X price ↓, X qty ↑ → XTR ↑ → C ↑ → AD ↑ → U ↓ ; M price ↑, M qty ↓ → MTE ↓ ⇒ BOT surplus (XTR > MTE)

Summary: monetary inflation occurs due to an increase in money supply → interest rate falls → savers save less and spend more, borrowers borrow more → C and I rise → AD ↑ → producers hire more labour → unemployment ↓. The multiplier effect gives mild inflation in the short run (prices rise slower than real income) but hyper-inflation in the long run (only prices rise).

Interest rate ↔ exchange rate (+ve): when the interest rate falls, our exports look cheaper → export quantity and revenue ↑; imports look more expensive → import quantity and expenditure ↓ ⇒ balance of trade surplus.

4. Inflation vs Disinflation vs Deflation

	Prices	Meaning
Inflation	↑	persistent and sustained increase in the general price level over a given period of time
Disinflation	↑ but slower	prices are still increasing but at a decreasing (slower) rate
Deflation	↓ (−ve)	persistent and sustained fall in the general price level over a given period of time

★ Marked R (remember): disinflation = prices still ↑, just at a slower rate.

Teacher's year table (as written on the board):

Yr1	Yr2	Yr3	Yr4	Yr5	Yr6	Yr7
102%	110%	116%	112%	108%	120%	−97%

Labels between years: 8% ↑ Inflation · 6% ↑ ″ · 4% ↓ Disinflation · 4% ↓ ″ · 12% ↑ Inflation · 23% ↓ Deflation (prices ↓ −ve).

Note: these figures are small and hard to read in the screenshot — focus on the labels and the rule for each term.

Practice: monthly change in the general price level

Jan	Feb	Mar	Apr	May	Jun	Jul	Aug	Sep	Oct	Nov	Dec
3.0%	2.6%	0.9%	−0.5%	−1.2%	−0.2%	2.1%	2.6%	4.1%	3.8%	3.6%	3.5%

Q: which periods show inflation? deflation? disinflation?

Jan – Mar → Disinflation (still positive, falling)
Apr – Jun → Deflation (negative)
Jul – Sep → Inflation (rising)
Oct – Dec → Disinflation (positive, falling)

★ Inflation → Prices ↑	★ Deflation → Prices ↓ (−ve)
Reasons: 1) AD ↑ 2) AS ↓ ⇒ shortage ⇒ prices ↑	Reasons: 1) AD ↓ 2) AS ↑ ⇒ surplus ⇒ prices ↓ ⇒ deflation

Inflation VS Deflation — the board's chains

Inflation	Deflation
Prices ↑ → consumption ↓ → AD ↓ → surplus → prices ↓ (deflation)	Prices ↓ → consumption ↑ → AD ↑ → shortage → prices ↑ (inflation)
producer: production ↓ → DL ↓ → unemployment ↑	producer: production ↑ → DL ↑ → unemployment ↓
With deflation, X price ↓, M price ↑ (relatively inflation abroad) → X qty ↑, M qty ↓ → XTR ↑, MTE ↓ → C ↑ → AD ↑ → shortage → prices ↑ (inflation)

5. Policies to Deal with Inflation

Policies to deal with inflation (prices ↑) → Target: 1) AD ↓ → Demand-side policy → Fiscal / Monetary policy (reason: AD ↑) | 2) AS ↑ → Supply-side policy (reason: AS ↓)

★ Macro-economic objectives

Price stability
Full employment
Economic growth
Redistribution of income / wealth
BOP stability

Objective: Price stability · Conflict: Full employment & Economic growth → so demand-side policy is a conflicting policy (fiscal / monetary).

Key idea: demand-side policy is conflicting — it always achieves one objective but conflicts with another. Controlling inflation achieves price stability but conflicts with full employment: when AD ↓, firms contract production ⇒ unemployment ↑.

Demand-side policy → target: AD ↓ → surplus → prices ↓ → Contractionary fiscal / monetary policy.

Fiscal policy = part of demand-side policy; tools: taxation and government expenditure, manipulated to influence AD and achieve macro objectives.

A. Contractionary Fiscal Policy → target AD ↓

Taxation ↑		Government exp ↓
Income tax ↑ → disposable income ↓ → purchasing power ↓ → consumption ↓ → AD ↓	Corporation tax ↑ → retained profits ↓ → reinvestment ↓ → investment exp ↓ → AD ↓	Roads ↓ → jobs ↓ → income ↓ → C ↓ → AD ↓ → U ↑

AD ↓ → producer: production ↓ → DL ↓ → Unemployment ↑ → output ↓, GDP ↓, low economic growth.

★ Budget = tax revenue − govt expenditure.
Surplus: T.R > G.E
Deficit: G.E > T.R

AD → AD₁: P ↓ (price stability) but Y ↓

Objective: price stability.

Conflict: full employment & economic growth.

P → P₁ ✓ but Y → Y₁ ⇒ output falls, unemployment ↑.

Answer paragraph: contractionary fiscal policy is used by the government to control inflation. An increase in taxation (income tax and corporation tax) reduces consumption and investment so AD falls. Along with this, a decrease in government expenditure reduces AD, controlling inflation, and signals producers to contract production, reducing demand for labour → unemployment ↑.

B. Contractionary Monetary Policy → target AD ↓

Monetary policy = part of demand-side policy; tools: money supply, interest rate, exchange rate, manipulated to influence AD.

Money supply / interest rate (−ve)	Interest rate / exchange rate (+ve)
MS ↓, r ↑ savers: save ↑ (rate of return ↑) → spend ↓ → C ↓ → AD ↓ borrowers: borrow ↓ (cost of borrowing ↑) → reinvestment ↓ → I.E. ↓ → AD ↓	r ↑, ER ↑ X price ↑, X qty ↓ → XTR ↓ → C ↓ → AD ↓ → U ↑ M price ↓, M qty ↑ → MTE ↑ ⇒ BOT deficit (MTE > XTR)

Board slip corrected: the page says "BOT surplus XTR > MTE" under the ER side, but with XTR ↓ and MTE ↑ the result is a deficit (MTE > XTR) — and the teacher's own written paragraph says Balance of Trade Deficit.

AD ↓ → producer: production ↓ → DL ↓ → unemployment ↑ → output ↓, GDP ↓, low economic growth.

MS → MS₁ (left): r ↑ to r₁

AD → AD₁: P ↓, Y ↓

Answer paragraph: a decrease in money supply raises the interest rate, so savers save more and spend less and borrowers borrow less → consumption and investment ↓ → AD ↓ → producers contract production → demand for labour ↓ → unemployment ↑. The higher interest rate raises the exchange rate, making exports expensive (export quantity and revenue ↓) and imports cheaper (import expenditure ↑) ⇒ balance of trade deficit.

C. Supply-Side Policy → target AS ↑

Supply-side policy → target: AS ↑ → surplus → prices ↓ | SRAS ↑ and LRAS ↑ (potential ↑)

SRAS ↑ — reasons:

Cost of production ↓
Provision of subsidy
Removal of indirect tax
Prices of raw materials ↓
Relocation of factory
Grants / schemes
Training / education to workers
Privatisation

SRAS → SRAS₁ (right): P ↓, Y ↑

P ↓ → price stability ✓

Y ↑ → R.I. ↑ → purchasing power ↑ ⇒ full employment, economic growth ✓

Answer paragraph: an increase in short-run AS from SRAS to SRAS₁ reduces the price level from P to P₁ (price stability) and raises real income from Y to Y₁ (purchasing power), achieving full employment — a non-inflationary growth policy.

Long-run AS ↑ (potential ↑)

LRAS ↑ → potential is increasing ⇒ PPC shifts outward. Reasons:

Discovery of natural resources
Technological advancement
Immigration of workers
Fall in price of energy
Population / labour force ↑
Quantity of capital goods ↑

potential ↑: PPC shifts out (A,B → C,D)

actual output reaches potential

Gap between actual and potential starts to decrease	Actual reaches potential
surplus of resources → price ↓ → hyper → mild inflation	shortage of resources → price ↑ → hyper-inflation

LRAS → LRAS₁: R.I. ↑ → R.P. ↑

Hyper-inflation converted into mild inflation — a shift in potential shifts the LRAS curve (LRAS → LRAS₁), so real income can rise instead of only prices.

Disadvantages of supply-side policy:
① Opportunity cost ② Costly ③ Long-term effect ④ Time-consuming
(money could have been spent elsewhere, e.g. subsidies or infrastructure; technology gives no immediate effect)

Answer paragraphs: supply-side policy is a macro policy that aims to increase short-run AS; it is a non-inflationary growth policy achieving price stability, full employment and economic growth without conflict. Its advantage: hyper-inflation gets converted to mild inflation due to the shift in potential (LRAS shifts). Its disadvantages: time constraint (effect is long term — technological advancement has no immediate effect) and the money could have been spent somewhere else.

6. Policies to Deal with Deflation

Policies to deal with deflation (prices ↓; reasons: AD ↓, AS ↑) → target: 1) AD ↑ → Demand-side policy → Fiscal / Monetary policy (cost / expenditure)

Objective: full employment & economic growth · Conflict: price stability ⇒ demand-side policy is again a conflicting policy.

Key idea: controlling deflation achieves full employment, but conflicts with price stability — when AD ↑ it brings hyper-inflation in the long run (only prices rise, real income constant).

A. Expansionary Fiscal Policy → target AD ↑

Taxation ↓		Government exp ↑
Income tax ↓ → disposable income ↑ → purchasing power ↑ → C ↑ → AD ↑	Corporation tax ↓ → retained profits ↑ → reinvestment ↑ → I.E. ↑ → AD ↑	Roads ↑ → jobs ↑ → income ↑ → C ↑ → AD ↑ → U ↓

AD ↑ → producer: production ↑ → DL ↑ → unemployment ↓ → output ↑, GDP ↑, economic growth ↑

Short run	Long run
Multiplier effect (I, O, E ↑) → mild inflation: prices ↑ 10%, R.I. ↑ 50%	Hyper-inflation: only price ↑, R.I. constant

AD₁ → AD₅ along the AS curve

Objective: full employment, economic growth.

Conflict: price stability — mild inflation first (P ↑10%, RI ↑50%), then hyper-inflation (P ↑50%, RI ↑10%, finally only P ↑).

Answer paragraph: expansionary fiscal policy is used to control deflation. A decrease in taxation (income tax and corporation tax) raises consumption and investment so AD rises; increase in government expenditure (e.g. roads) also raises AD and signals producers to expand production → demand for labour ↑ → unemployment ↓. The multiplier effect keeps income, output and employment rising: mild inflation in the short run (prices rise slower than real income) but hyper-inflation in the long run.

B. Expansionary Monetary Policy → target AD ↑

Money supply / interest rate (−ve)	Interest rate / exchange rate (+ve)
MS ↑, r ↓ savers: save ↓ (rate of return ↓) → spend ↑ → C ↑ → AD ↑ borrowers: borrow ↑ (cost of borrowing ↓) → reinvestment ↑ → I.E. ↑ → AD ↑	r ↓, ER ↓ X price ↓, X qty ↑ → XTR ↑ → C ↑ → AD ↑ → U ↓ M price ↑, M qty ↓ → MTE ↓ ⇒ BOT surplus (XTR > MTE)

AD ↑ → producer: production ↑ → DL ↑ → unemployment ↓ → output ↑, GDP ↑, EG ↑. Short run: multiplier effect (I, O, E ↑) → mild inflation (P ↑10%, RI ↑50%); long run: hyper-inflation (P ↑, RI constant).

MS → MS₁: r ↓ to r₁

AD ↑ → mild then hyper-inflation

Answer paragraph: an increase in money supply lowers the interest rate, so savers save less and spend more, borrowers borrow more → C and I ↑ → AD ↑ → production, employment and output ↑. The lower interest rate lowers the exchange rate: exports become cheaper (XTR ↑) and imports dearer (MTE ↓) ⇒ BOT surplus.

7. Quick Recap — Full Chapter Cheat-Sheet

✓ Definitions & formulas

Inflation: persistent, sustained ↑ in general price level · Disinflation: prices ↑ at a slower rate · Deflation: persistent ↓ in prices
AD = C + I + G + (X − M) · BOT = XTR − MTE (surplus XTR > MTE, deficit MTE > XTR)
RI % = NI % − Inflation % · Real interest rate % = nominal interest % − inflation %
Inflation reasons: AD ↑, AS ↓ (shortage) · Deflation reasons: AD ↓, AS ↑ (surplus)
M.S and r → −ve · r and ER → +ve

✓ Effects of inflation (#1–#9)

#1 unemployment ↑ · #2 BOT deficit · #3 depreciation · #4 real income ↓ · #5 savers (saving discouraged) · #6 lenders hurt, borrowers gain · #7 menu cost · #8 shoe-leather cost · #9 fixed-income / pension earners hit hardest
Evaluation: anticipated vs unanticipated · internal vs external · exchange-rate system

✓ Causes & policies

Cost-push (AS ↓): cost of production ↑, indirect tax, subsidy removed, raw materials ↑, imported inflation, wage-price spiral
Monetary inflation: MS ↑ → r ↓ → AD ↑ → mild inflation (short run), hyper-inflation (long run)
Inflation: contractionary fiscal (tax ↑, G ↓) / monetary (MS ↓, r ↑) → AD ↓ → price stability ✓ but unemployment ↑ ✗ · supply-side (SRAS ↑, LRAS ↑) → non-inflationary growth, but costly, slow, opportunity cost
Deflation: expansionary fiscal (tax ↓, G ↑) / monetary (MS ↑, r ↓) → AD ↑ → full employment ✓ but hyper-inflation in long run ✗