Macroeconomics 10: Case Study Analysis of Inflation and Deflation

This case study analyzes macroeconomic concepts such as inflation and deflation, using the Turkish economy as a real-world example. The analysis begins with an examination of inflation, its types, and the factors influencing the Consumer Price Index (CPI), including the impact of food and energy prices. The study then explores the causes and consequences of inflation, as well as government responses through monetary policy, such as contractionary measures. The second part of the case study shifts to deflation, its impact on the Japanese economy, and the role of the COVID-19 pandemic in triggering deflation. The study explores the use of quantitative easing (QE) and bond-buying programs to combat deflation. Finally, the case study compares and contrasts inflation and deflation, highlighting their effects on economic activity, consumer behavior, and the role of monetary policy in managing these economic phenomena. The document includes the impact of various economic factors and government policies.

Running head: MACROECONOMICS
Macroeconomics: Case study analysis
Name of the Student:
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Table of Contents
CASE STUDY 1..............................................................................................................................2
Answer 1......................................................................................................................................2
Answer 2......................................................................................................................................2
Answer 3......................................................................................................................................2
Answer 4......................................................................................................................................3
Answer 5......................................................................................................................................4
Answer 6......................................................................................................................................4
CASE STUDY 2..............................................................................................................................5
Answer 1......................................................................................................................................5
Answer 2......................................................................................................................................5
Answer 3......................................................................................................................................6
Answer 4......................................................................................................................................6
Answer 5......................................................................................................................................7
References........................................................................................................................................9

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CASE STUDY 1
Answer 1
Inflation refers to the increase in the average price level in an economy. As stated by
Megaravalli (2019), the rate at which the average price of a basket of selected products and
services in a country rises over a certain period of time is known as inflation. It decreases the
purchasing power of the currency of a nation, and hence, cost of living increases due to inflation,
as people need to spend more money than earlier to purchase same unit of goods and services. It
is of two types, demand pull and cost push. When demand outpaces the supply in the market,
demand pull inflation occurs. On the other hand, when supply is constrained but demand is not, it
generates cost push inflation (Heijdra 2017).
Answer 2
CPI refers to Consumer Price Index, which is the measure of the cost of living while core
CPI is the CPI excluding the value or prices of food and energy (Church 2016). The above
mentioned factors are excluded from CPI to obtain the core CPI because these prices are highly
volatile. The difference between CPI and core CPI indicates the volatility of prices of food and
energy, which affects the household budgets and consumptions maximum (IMF 2020). Turkey
has been experiencing a very high inflation rate over the past few years, which reached highest in
15 years to more than 25% in October 2018, while it dropped in 2019 and in March 2020, the
inflation dropped to 11.86% (Daily Sabah 2020). It has been noticed that drop in the global oil
prices lowered the inflation rate to 11.86%, and the energy prices and the prices of fresh fruit and
vegetables decreased significantly, which contributed in the slowdown in CPI. On the other
hand, the price of non-fresh fruit and vegetables increased during this time. Thus, it can be said
that while the CPI of turkey is falling with an expectation to reach single digit, with dropping of
global oil price and fall in food inflation from 10.6% in February to 10.1% in March, 2020, the
core CPI continues to increase (Mercan 2020).
Answer 3
The prices of vegetables are highly volatile. Thus, these prices are excluded while
calculating the core CPI (Felis and Garrido 2015). The vegetable price fell significantly in

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Quantity supplied in
domestic market
Price
P1
Q1
P2
Q2
D
S1
S2
turkey, affecting the overall inflation rate in March, 2020. The reason for this can be attributed to
the increase of supply of vegetables in the domestic market. Due to the coronavirus outbreak, the
borders of Iraq and Iran are closed and that negatively affected the exports of vegetables to the
neighboring countries. Therefore the domestic supply of vegetables increased considerably,
which pushed down the vegetable price in the domestic market.
Figure 1: Impact of increase in vegetables supply in domestic market
Figure 1 shows that the supply curve shifted rightward due to increase in vegetable
supply in the domestic market resulting from fall in export, and while demand remaining same,
the quantity supplied increases and price falls, influencing the CPI.
Answer 4
Speculation of further inflation is one of the causes that triggers inflation in an economy.
Rise in the price level creates an expectation of a rise in the wage of the workers. This hike in
wage pushes up the cost of production and that results in a cost push inflation in the economy.
On the other hand, if the wage level increases, then people have more money to spend and as
they expect that the price level would rise again, their demand for goods and services increases,

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creating excess demand in the market. It then causes demand pull inflation in the economy
(Grasselli and Huu 2015).
Answer 5
Continued inflation has adverse effects for any economy. Inflation results in decreasing
purchasing power of the currency. Hence, in case of continued inflation, the value of money
continuously depreciates. This in turn have a positive impact on the exports of the country.
Currency devaluation makes the exports of the nation cheaper and imports more expensive,
which leads to rise in the export volume and fall in the import volume. Thus, a high inflation rate
of an economy is likely to have a favorable exchange rate for the country (Yildirim and Ivrendi
2016), and hence, it can be said that continued inflation in Turkey raises domestic price level but
it also raises exports for the country as the value of the exports from Turkey in terms of foreign
currency falls.
Answer 6
To cut the inflation rate in the economy, the government can adopt contractionary
monetary policy. Under this policy, the money supply in the economy is restricted or controlled.
The government raises the interest rates and decreases the bond prices. These measures help in
reducing the money supply in the economy as spending is discouraged. When interest rate is
increased by the government, people are encouraged to save more as lending becomes costlier.
Availability of credit also becomes less which negatively affects the spending level. All these
actions lead to less amount of money circulation in the economy, lowering the demand for goods
and services and halting the growth of inflation (Glas and Hartmann 2016).
Secondly, the government increases the reserve requirement for the commercial banks.
This is the amount of money that the commercial banks are legally required to hold for covering
withdrawal. Hence, the larger amount that the banks need to hold back, the less is available to
give or lend to the consumers (Bernanke et al. 2018). This in turn reduces borrowing and
spending level, preventing inflation hike. Thus, it can be said that the Turkish government may
follow the above mentioned measures to control inflation in the economy.

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Real GDP
AD1
AD2
Y1Y2
LRAS
P1
P2
Price Level
CASE STUDY 2
Answer 1
Deflation is the opposite of inflation. The fall in the average price level in an economy
over a certain period of time is called deflation. In deflation, the consumer prices and asset prices
fall significantly over time. It increases the purchasing power or value of the currency of an
economy, and deflation implies a long-term fall in the aggregate demand in an economy.
Deflation also signals an impending recession (Heijdra 2017).
Answer 2
The coronavirus pandemic is hitting the economy of Japan quite hard. The economy was
making recovery from long deflation while the pandemic started to affect its growth, once again
pushing for deflation. Deflation can arise from two situations, such as, decreasing aggregate
demand (AD) and lowering cost of production. When deflation occurs from decreasing cost of
production, then it is called good deflation. In this situation, consumers need to pay lower price,
while output increases due to increase in productivity. On the other hand, deflation occurring
from falling AD in the economy, it is called bad deflation (Heijdra 2017). Considering Japan’s
situation, it is suffering from bad deflation due to diminishing AD.

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Figure 2: Impact of decreasing AD
Due to the coronavirus outbreak, the wage growth and jobs are getting negatively
affected in Japan. The wages are hurt, consumption has been falling and the retailers are
considering job cuts, which is pushing the economy towards recession. There is sharp fall in the
aggregate demand (AD) in the economy and consumer prices will start to fall due to excess
supply in the market (Kihara and Kaneko 2020). Thus, the country is facing another round of
deflation. The AD-AS diagram above depicts the type of deflation in Japan.
Answer 3
The consequences of deflation triggered by the COVID-19 pandemic will be severe for
Japan. The lockdown and restriction of travel and transportation has been lowering the demand
for oil and the first hit on the economy is from the slumping oil price. At the same time, the
consumption level has lowered substantially, reflecting diminishing consumer demand and
creating excess supply in the market. Core consumer prices are falling, due to which the
businesses are unable to raise their costs and hence, they are opting for massive discounts, at the
cost of profit. Job cuts will also rise in future as the businesses are unable to cover their cost of
production. Due to deflation, the firms will have less money for spending on wages of the
employees and on the equipment, and that in turn lowers the household consumption and
spending, that is, further fall in AD will occur (Kihara and Kaneko 2020). Thus, Japan will again
enter into a stage of deflation and recession due to the pandemic.
Answer 4
Bond-buying program is a measure under the unconventional monetary policy,
Quantitative Easing (QE). Under this monetary policy, the central bank purchases the long term
securities and predetermined quantity of government bonds for increasing the money supply into
the economy and stimulate the lending, borrowing, investment and other economic activities.
Purchase of these bonds serves to the lower interest rates through bidding up the fixed income
securities (Gagnon 2016). When the short term interest rate is zero or approaching zero, the
conventional open market operations are not effective for increasing money supply in the
economy and hence, a specific amount of asset purchase by the central bank is more effective

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(Christensen and Gillan 2018). Hence, to fight the deflation, Bank of Japan will purchase more
bonds that will lower the cost of money, and at lower interest rate, the commercial banks can
lend money at easier terms, which will push the economic activities.
Answer 5
Inflation refers to the increase in the general price level of an economy over a certain
time period, while deflation is the fall in the price level. Extremities of both the situation can
potentially be bad for an economy depending on the rate of change in the price level, and the
causes. Under deflation, either there are too many goods and services in the economy than
demand or there is not adequate money circulating for purchasing the goods. Fall in aggregate
demand is a major reason for deflation. In this situation, all the economic activities lose their
pace, people reduce their consumption and spending, level of borrowing and investment in the
economy falls and eventually the real GDP falls significantly, affecting the economic growth
(Heijdra 2017). The central bank lowers interest rate to increase money supply and fight
deflation in the economy. Bank of Japan opted for negative interest rates in 2016 to fight long
running deflation in the economy (Blanke and Krogstrup 2016). However, during deflation, the
money supply in the economy is tightened due to increase in the real interest rates, which
influences the consumers to save money than spending. This situation hinders the growth of
revenue of the firm, resulting in pay cuts of the workers or lay off. Thus, this would lead to
higher unemployment and lower growth of the economy (Megaravalli 2019). The pay cuts
become inevitable during deflation as the firms cannot raise expected revenue. This affects the
moral of the workers quite negatively, and that gets reflected in their productivity and output
level. Hence, deflation has quite significant demoralizing effect.
On the other hand, inflation can be handled by adjusting the interest rate. In inflation,
there is too much money in the economy creating excess demand than supply in the market.
Hence, to control the money supply, the government raises the interest rate. It makes borrowing
costlier and people are encouraged to save more than spending (Hansen 2016). To fight
deflation, the government has to opt for large fiscal injections, such as, increasing government
expenditure and cutting the taxes. To push the aggregate demand in the economy and keep it
running, government invests and spends, and also lowers tax rates, so that people have more

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money to spend. However, opting for large fiscal injections would hurt the revenue growth of the
government and would lead to lead fiscal deficit (Bagus 2015).
Inflationary expectations of people can be controlled by raising interest rates and inflation
has the opportunities for increasing the output of the nation, which eventually leads to economic
growth. On the other hand, controlling deflationary expectations would lead to continuously
lowering interest rates, which might lead to negative interest rate and people might still have
expectation of price fall and they would hoard the money than spending. It causes a major hit to
the GDP (Megaravalli 2019). As seen from the example of Japan, increasing the long run
aggregate supply (LRAS) created further deflationary tendencies in the economy. Increasing
LRAS implies supply shock. Since, under deflation, the average price level of the economy falls,
people’s deflationary expectations would continue to increase. In other words, in such situation,
people would hoard money with the expectation of further fall in price of the goods and services.
According to the law of demand and supply, when supply of a good increases, its price falls.
Hence, in the long run, if the government increases the supply of goods and services, the average
price level declines, creating further deflation. At the same time, people would expect a further
fall in prices and hence, would not spend, which also causes a pressure on the price level (Hattori
and Yetman 2017). Hence, although, the output increases in the long run, the businesses run in
losses, there is lack of revenue and profit, affecting wage growth of the workers and thus, a
deflationary cycle is created. Therefore, it can be concluded that extreme inflation and deflation
are both bad for an economy, however, in a comparative level, deflation is all the more bad for
an economy than inflation.

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