inflation is a sustained increase in the general level of prices inflation rate is the annual %...
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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
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