Inflation is a sustained increase in the general level of prices Inflation rate is the annual % change in prices

A fall in inflation means that prices are rising but at a slower rate than before.

When prices rise, the real purchasing power of cash declines

Deflation on the other hand is a sustained decrease in general prices

ANNUAL PERCENTAGE CHANGE IN RPI COMPONENTS

6.7

4.1

4.1

3.7

3.6

3.3

2.5

2.5

2.2

1.2

-1.3

-1.4

-1.9

-5.3

-6 -4 -2 0 2 4 6 8

Leisure Services

Household Services

Food

Personal Goods & Services

Alcoholic Drink

Motoring Expenditure

Leisure Goods

So

urc

e: O

NS

CP

I D

ata

Mar

ch 2

002

% Change over 12 Months

Inflation has two main causes Demand – pull inflation

When aggregate demand is rising faster than the ability of the economy to supply goods and services – leading to excess demand

Positive output gap (when actual GDP > Trend GDP) Businesses respond by raising prices to increase their profit

margins Demand-pull inflation associated with the boom phase of the

economic cycle Cost – push inflation

Occurs when costs of production are increasing This leads to inward shift in short run aggregate supply Firms raise prices to protect their profits Wages often follow prices – if there is an increase in inflation, this

may lead to a rise in pay claims – this is known as a wage price spiral

Real National Output

Price LevelSRAS1

Y1

AD1

P1

Real National Output

Price LevelSRAS1

Y1

AD1

P1

AD2

Real National Output

Price LevelSRAS1

Y2

P2

Y1

AD1

P1

AD2

Real National Output

Price LevelSRAS1

Y2

P2

Y1

A higher level of aggregate demand

(e.g. caused by rising consumer spending)

puts upward pressure on the price level

AD1

P1

AD2

Real National Output

Price LevelSRAS1

Y1

AD1

P1

Real National Output

Price LevelSRAS1

Y1

SRAS2

AD1

P1

Real National Output

Price LevelSRAS1

Y2

P2

Y1

SRAS2

AD1

P1

Real National Output

Price LevelSRAS1

Y2

P2

Y1

Shifts in AS are caused by changes in input

costs –

for example a rise in oil prices leads to higher costs and an inward shift of SRAS – and a higher general price

level

SRAS2

AD1

P1

Earnings

Productivity

Unit labour costs

Import Prices

Commodity Prices

Taxes

Profit Margins

inflation

Basic Pay

Bonuses + overtime

Secular Influences

(e.g. ICT impact)

Economic Cycle

Economic Cycle

Fiscal Policy

Global Economic Cycle

Exchange rate / Profit margins

+ =

+

+

+

Economic costs of inflation depend on The degree of inflation – more costly when inflation is high Whether inflation is

Correctly anticipated by consumers and producers Unanticipated – I.e people’s expectations of inflation turn out to be

wrong Whether inflation in one country is higher than in other countries Whether the exchange rate adjusts to restore lost price and cost

competitiveness for exporters High and variable inflation usually creates more economic

costs than low and stable rates of price inflation Volatile inflation – diverts resources towards protection from

its effects rather than a productive contribution to extra output

We can make a distinction between micro and macro-economic costs of inflation

Inflation leads to a re-distribution of income and wealth From lenders to debtors if real interest rates become negative Away from those on fixed incomes or with weak bargaining power

Loss of international competitiveness (when relative inflation is high) Impact on exports (loss of market share) Imports become relatively cheaper (rising import penetration) Worsening of the international trade performance

Monetary policy response to high inflation –i.e. higher (nominal) interest rates – which has negative effect on real output, investment and employment

Loss of business confidence (lower planned investment) due to uncertainty and lower expected real rates of return on capital

Shoe-leather and menu costs

Hungary experienced hyperinflation on this scale

1939 Price Index (PI) = 100 Jan 1946 PI = 5,371,300 June 1946 PI = 19,686,163,000,000

A more recent example is Zimbabwe- where due to Hyperinflation the currency became worthless. When this happens, you need an alternative currency, or you end up with a barter economy.

Policies should focus on the causes of inflation: Demand-pull inflation:

Requires control of aggregate demand Aim: reduce the a positive output gap “Deflationary policies” to reduce real incomes and

spending Cost-push inflation:

Requires policies to control unit costs of production Policies that stimulate competition and keep prices

down in markets and industries Policies that increase aggregate supply potential in

the economy (in particular an increase in LRAS)

Demand-Pull Inflation Higher interest rates

Increase in direct taxes such as income tax

Cuts in real level of government spending

If the Government runs a Budget Surplus, this is a net withdrawal from the circular flow (helps to reduce AD)

Cost-Push Inflation Higher exchange rate Direct controls on

wages and prices Measures to stimulate

increased competition Policies designed to

increase labour productivity (AS)

Expansionary Monetary Policy

Lower Nominal Interest Rates

Stimulates Capital Investment

Increase in AD

Expansionary Monetary Policy

Increased demand for credit

Stimulates Consumer Spending

Increase in AD

Expansionary Monetary Policy

Exchange Rate Depreciation

Stimulates Net Exports

Increase in AD

Expansionary Monetary Policy

Rise in Equity Prices

Rise in Land and House Prices

Rise in Value of Financial Wealth

Increase in AD

INTEREST RATE CHANNEL

BANK LENDING CHANNEL

EXCHANGE RATE CHANNEL

WEALTH EFFECT CHANNEL

1993-2001 – a return to the low and stable inflation last seen in the 1950s and 1960s

Several factors explain the absence of inflation Subdued growth of wages and earnings (below 5%) Absence of major inflationary shocks such as a sharp jump in

international commodity prices (although Oil in 2008 could have caused this if it had continued

Success of Central Banks in keeping aggregate demand under control through interest rate changes

Much greater competitive pressure in many industries Strong pound has helped to keep inflation under control Expansion of information technology has helped to reduce

costs Cuts in the prices charged by many of the privatised utilities Expectations of inflation have fallen!

Low stable inflation can provide a boost to economic growth

Easier for productivity improvements to show through in higher real wages

Gentle rise in prices boosts company earnings and gradually erodes the real value of debt

2-3% inflation gives some scope for relative prices to change in the economy reflecting changes in supply & demand conditions

Price deflation A fall in the internal price level

Economy-wide deflation is rare but many individual examples exist in specific industries and markets Farm prices in 1999-2001 House prices in the early 1990s Coffee prices

Shift in thinking of economic policy-makers (fearing a return to the inflation of the 1970s and 1980s – widespread adoption of inflation targets)

Decline in inflation expectations. Consumers are now more price conscious - harder to make price increases stick (increase in price elasticity of demand?)

Change in the of the structure of the economy Declining importance of manufacturing (33% of GDP in 1970 down to 19%

in 2000) Long run decline in trade union membership – less upward pressure on real

wages Impact of deregulation (higher market supply drives prices lower)

Intensity of price competition from the East - massive pool of cheap labour aiming at the "inflationary weak spot of Western nations - manufacturing"!

The information & communication revolution (ICT) - can undermine monopoly power through the costless transmission of price information – but the impact of e-commerce should not be exaggerated