Inflation

1. Inflation A2 economics revision presentation on the measurement of inflation; the causes and consequences of inflation and economic policies to control inflation

2. Defining inflation • Inflation is defined as a sustained increase in the average price level • The rate of inflation is measured by the annual percentage change in the level of prices as measured by the retail prices index • The Retail Price Index (RPI) measures the average change from month to month in the prices of goods and services purchased by most households • The RPI is compiled using a representative selection of more than 600 separate goods and services for which price movements are regularly measured in 146 areas throughout the UK • Some 130,000 separate price quotations are used each month in compiling the index, which is published each month

3. Recent changes to the retail price index ‘basket’

4. Different measures of inflation • Headline inflation (RPI) • The headline rate - all items in the retail price index are counted in this measure of inflation • Underlying inflation (RPIX) • The underlying rate excludes mortgage interest costs and is the one favoured by the Treasury – this is the rate that is the subject of the inflation target • Harmonised index of consumer prices (HICP) • The harmonised index of consumer prices (HICP) a standardized measure of price inflation used to compare the inflation performance of countries inside the European Union

5. Limitations of the retail price index • The RPI is not fully representative • Since the RPI represents the expenditure of the ‘average’ household, it may be inaccurate for the ‘non-typical’ household • Housing Costs • The ‘housing’ category of the RPI records changes in the costs of rents, mortgage interest, property insurance, repairs, etc. It accounts for around 16% of the index. Housing costs vary greatly from person to person • The Changing Quality of Goods and Services • Although the price of a good or service may rise, this may be accompanied by an improvement in quality as the good is updated reflecting improvements in dynamic efficiency in the market-place

6. Long term trends in UK inflation RPI RPIX

7. Inflation in the UK since 1988

8. Annual rates of inflation

9. RPI inflation since the Bank became independent

10. Selected International Inflation Data

11. The main causes of inflation

12. Mapping the main causes of inflation in the UK Exchange rate / Profit margins Import Prices Basic Pay Bonuses + overtime Global Economic Cycle + Commodity Prices Unit labour costs RPIX inflation Earnings = + + Productivity Taxes + Fiscal Policy Secular Influences (e.g. ICT impact) Economic Cycle Profit Margins Economic Cycle

13. Demand-pull inflation • Demand – pull inflation • When there is excess AD for goods and services • i.e. a positive output gap (where actual GDP > Potential GDP) • Businesses respond by raising prices to increase their profit margins • Demand-pull inflation associated with the boom phase of the cycle (when SRAS becomes inelastic) • Root causes of demand pull inflation are usually monetary in origin • E.g. excessive growth of money demand / credit • High levels of consumer spending

14. Main causes of demand pull inflation • A depreciation of the exchange rate increases the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while exports grow, AD in will rise • A reduction in direct or indirect taxation. If direct taxes are reduced consumers will have more disposable income causing demand to rise • Rapid growth of the money supply as a consequence of increased bank and building society borrowing • Rising consumer confidence and an increase in the rate of growth of house prices • Faster economic growth in other countries – providing a boost to UK exports overseas

15. Illustrating demand-pull inflation General Price Level LRAS SRAS1 P2 P1 AD2 AD1 Y1 National Income Yfc Y2

16. SRAS responds to excess aggregate demand General Price Level LRAS SRAS2 SRAS1 P3 P2 P1 AD2 AD1 Y1 National Income Yfc Y2

17. Demand-pull inflation using a non-linear AS curve General Price Level LRAS P3 P2 P1 AD3 AD2 SRAS AD1 Real National Income Y2 Yfc Y1

18. Cost Push Inflation • Occurs when costs of production are increasing • Causes: • External economic shocks (commodity price fluctuations) • A depreciation in the exchange rate • Acceleration in wages and earnings as labour market tightens • This leads to inward shift in short run aggregate supply curve • Firms raise prices to protect their profit margins – better able to do this when market demand is price inelastic • “Wages often follow prices” – an increase in inflation may lead to a rise in pay claims – this is known as a wage price spiral • A rise in actual inflation can lead to an increase in inflationary expectations

19. Illustrating cost-push inflation LRAS SRAS2 SRAS1 P2 P1 AD1 Y1 National Income Y2 Yfc

20. Illustrating cost-push inflation – with a non-linear SRAS LRAS General Price Level P2 P1 SRAS2 SRAS1 AD1 AD2 Y2 Yfc Y3 Y1 Real National Income

21. Recent trends in oil prices

22. The consequences of inflation ‘Taken together, the verdict of economics, history and common sense is that inflation and deflation are costly. It is clear that very high inflation – in extreme cases hyperinflation – can lead to a breakdown of the economy. There is now a considerable body of empirical evidence that inflation and output growth are negatively correlated in high-inflation countries. For inflation rates in single figures, the impact of inflation on growth is less clear.’ Mervyn King adapted from a speech entitled “The Inflation Target – Ten Years On” given in 2002

23. Costs and Consequences of Inflation • Money loses its value and people lose confidence in money as the value of savings is reduced • Inflation can get out of control - price increases lead to higher wage demands as people try to maintain their living standards. This is known as a wage-price spiral. • Consumers and businesses on fixed incomes lose out because the their real incomes falls • Employees in poor bargaining positions lose out • Inflation can favour borrowers at the expense of savers – because inflation erodes the real value of existing debts • Inflation can disrupt business planning and lead to lower investment • Inflation is a possible cause of higher unemployment • Rising inflation is associated with higher interest rates - this reduces economic growth and can lead to a recession

24. Anticipated and unanticipated inflation • Anticipated inflation: • When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects • For example, trade unions may exercise their collective bargaining power to negotiate with employers for increases in money wages so as to protect the real wages of union members • Unanticipated inflation: • Unanticipated inflation occurs when economic agents (people, businesses and governments) make errors in their inflation forecasts • Actual inflation may end up well below, or significantly above expectations causing losses in real incomes and a redistribution of income and wealth from one group in society to another

25. Government policies to control inflation • Monetary policy • Use of interest rates • Manipulation of the exchange rate • Fiscal policy • Changes in direct taxation to influence disposable income and spending • Supply-side policies • Designed to boost LRAS and reduce unit labour costs • Direct price and wage controls

26. Base rates and inflation

27. Explaining the recent low rate of inflation in the UK • 1993-2003 – 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 • Success of the Bank of England 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 privatized utilities • Expectations of inflation have fallen!