Inflation and deflation

You already know that controlling inflation is the main economic objective for the government.  This section will outline how inflation is measured, its costs and how we prevent it.

 

Inflation is the annual percentage increase in prices.  When inflation occurs, the value of money will fall and you will be able to buy less with your money.

 

Measuring Inflation

There are a number of different measures of inflation.

 

Consumer Prices Index (CPI)

The Consumer Prices Index (CPI) is used by the government and Bank of England for the purpose of setting the target rate of inflation.   The present inflation target in the UK is 2.0%.

 

 

CPI was developed to be identical to the Harmonised Index of Consumer Prices (HICP) which is based upon an internationally agreed set of measurements. This allows HICP to be used for international comparisons of inflation.

 

The Office of National Statistics (ONS) collects about 120,000 prices every month for a ‘basket’ of about 650 goods and services. The change in the prices of these items is used to calculate the change in CPI.  The CPI is described as a weighted average price index; this means that each item has a weighting that relates to the percentage of household income that is spent on each item.

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The contents of the CPI basket are reviewed every year so the rate of inflation better reflects what UK households are consuming.  Broccoli and olive oil replace Brussels sprouts and vegetable oil.  Sat Nav systems are now in the basket, as are DAB radios which replaced

radio/CD/ cassette players.

 

Digital cameras have been in the basket since 2004. In 2007 was included in place of mail order developing. Recordable DVDs replace blank VHS tapes and video cassette recorders drop out of the basket, reflecting falling spending as households switch to DVD recorders.

 

The weight assigned to each sector (see above pie chart) will change each year to reflect changes in spending patterns.  The information below identifies the changes that have been made to the weights.

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The main problem of using a measure such as the CPI is that it may not reflect the change to your cost of living, for example, the rate of inflation for the following groups is likely to be very different:

  • Urban and rural households
  • Rich and poor households
  • Elderly and students

 

Retail Prices Index (RPI)

The RPI is used to calculate increases in pensions and other state benefits and has been calculated in the UK since June 1947.  It is calculated in a very similar manner to the CPI, but they use slightly different baskets.  The results of the differences are that RPI tends to be lower than CPI.

UNDERLYING INFLATION (RPIX)

RPIX is calculated in the same way as RPI, but it excludes mortgage interest payments.  This is because when interest rates are increased to control inflation, the immediate effect is to increase mortgage interest payments and, therefore, inflation.  RPIX target of 2.5% was used by the Bank of England from 1997 until the end of 2003.

 

RPIY INFLATION

RPIY, or the core rate of inflation, is based upon the RPI, but it excludes indirect taxes and the council tax.  This allows the figures to simply reflect changes to the price level rather than changes in taxation.

 

Harmonised Index of Consumer Prices (HICP)

The HICP, otherwise known as the CPI in the UK, was launched in 1997 as it was necessary to have a single measure of inflation across Europe.  Figures are released for the Euro-zone and individual countries.

 

Producer Price Index (PPI)

The Producer Price Index reflects the prices of the goods bought and sold by UK manufacturers.  The output price index, otherwise known as factory gate prices, measures prices of goods sold. The input index measures the prices of raw materials purchased by manufacturers.

 

History of Inflation in the UK

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Source: http://www.bankofengland.co.uk/publications/PublishingImages/inflationreport/cpimktnov12large.gif

Causes of Inflation

There are three explanations for inflation in the economy.

 

DEMAND PULL INFLATION

Demand Pull inflation will occur when there is an increase in consumption, investment, government spending or exports minus imports.  This will lead to aggregate demand shifting to the right.  In simple terms demand pull inflation can be explained by businesses putting up their prices if they see that there is lots of demand in the economy.

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The elasticity of the AS curve will affect the level of demand pull inflation that arises from an increase in AD.  There will be higher demand pull inflation if there is a relatively inelastic aggregate supply curve.

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There will be less of an impact upon the price level if the aggregate supply curve is a relatively elastic.

 
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COST PUSH INFLATION

Cost push inflation will occur when the short run aggregate supply curve shifts to the left.  It reflects that an increase in the firm’s costs will lead to increases in the price level.

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If there is an increase in a business’s costs it won’t always lead to an increase in the price level, particularly if the good or service it is selling has an elastic demand.

Monetary inflation

Monetary inflation will occur when there is an increase in the money supply (the amount of money in the economy).  Economic agents will spend the extra money and this will lead to an increase in aggregate demand.

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Demand Pull and Cost Push Inflation

It is possible for both demand pull and cost push inflation to occur at the same time.  An increase in wages would lead to cost push inflation, but the rise in wage would lead to an increase in consumption and demand pull inflation.

 

Possibly the greatest economics video ever.  No, it is the greatest economics video ever.  Sit back, relax and let the inflation monster roll!

Costs of Inflation

Inflation is far more damaging when it is unanticipated; it disrupts the planning of both businesses and consumers.  It is possible to try and guard against inflation by investing money and trying to earn a rate of interest greater than the rate of inflation, a positive real rate of interest (real rate of interest = rate of interest – rate of inflation).

 

Menu costs

Businesses will have to change their price lists, labels, brochures and vending machines after an increase in the price level.

 

Shoe leather costs

When price change people have to spend longer searching for the best price; this involves lots of walking around and therefore as your shoes wear out your shoe leather costs increase.  Shoe leather costs may not be so much of a problem today as 25 years ago due to the power of the internet in enabling you to search very quickly.

 

Decrease in UK Competitiveness

If the UK has higher inflation than the rest of the world its prices will rise in comparison to other countries.  This will reduce the level of aggregate demand in the UK.

Wage-price Spiral

An increase in wages and prices can lead to an upward spiral that is difficult to control.  If there is an increase in inflation workers will want an increase in their wages to enable them to maintain their living standards.  After wages have increased, businesses might have to do to their prices to cover the increase in costs.  Once prices rise again, workers will again want another increase in their wages.

 

This is the problem of a wage-price spiral: workers demand higher wages when prices rise, but that in turn will cause prices to rise.

 

Reduced standard of living for those on fixed income

The value of people’s fixed incomes will fall when there is inflation.  Many retired people are on fixed pensions, state pensions and benefits are increased each year in line with inflation.

 

Fall in value of savings

Inflation reduces the real value of saving.  If the rate of interest is 4% and inflation is 7%, the real rate of interest is minus 3%.  The value of savings falls when there is a negative real interest rate.

Disruption of the Price Mechanism

When prices are constantly changing due to inflation, the price mechanism might fail to allocate resources efficiently.  The rationing, signalling and incentives functions of price will cease to convey the correct messages.

 

Policies to Control Inflation

Most of these policies will be covered in much greater detail in later chapters; this section is a simple overview and there will be references to other chapters.

 

Monetary Policies – Interest Rates

See ‘Monetary Policy’ for a more detailed explanation.

The Bank of England set the rate of interest with the aim of achieving a rate of inflation of 2% using the CPI measure.

 

An increase in the rate of interest will lead to a decrease in aggregate demand.

 

An increase in interest rates will affect the various components of aggregate demand as follows:

  • Consumption – will fall as higher interest rates:
    • Make it more expensive to borrow money, therefore fewer items will be bought on credit.
    • Mortgage repayments will increase, meaning that homeowners will have less money to spend on consumption.
    • Provide a greater incentive to save rather than spend.
    • A fall in consumer confidence
    • Investment – will decrease due to:
      • Decline in business confidence.
      • Increase in the cost of borrowing money.
      • Government spending – is unlikely to be affected as governments have their own objectives.
      • Exports and imports – exports will become more expensive and fall in volume, whilst imports will rise as they get cheaper.

 

Monetary Policy – Money Supply

See ‘Monetary Policy’ for a more detailed explanation.

Higher interest rates will reduce the demand for loans and credit, therefore the money supply will fall and reduce inflationary pressure.

 

Monetary Policy – Exchange rates

See ‘Monetary Policy’ for a more detailed explanation.

Strengthening the pound will lead to exports becoming more expensive and falling in volume, whilst imports will rise as they get cheaper.

 

Fiscal Policies

See ‘Fiscal Policy’ for a more detailed explanation.

Fiscal policies relate to government spending and taxation.  The following fiscal policies can be used in an attempt to reduce aggregate demand:

  • Increasing direct taxes (income tax and corporation tax).
  • Raising indirect taxes (VAT and excise duties) will make goods and service more expensive.
  • Reducing the level of government spending will lead to aggregate demand shifting to the left.

 

INCOMES POLICIES

Incomes policies, also known as direct wage controls, puts limits on the increases in wages.  This policy was used up to the mid 1970s, although the government is able to limit the wage increases given to public sector workers.

 

Supply Side Policies

See ‘Supply Side Policies’ for a more detailed explanation.

These will aim to shift the aggregate supply curve to the right and lower the price level, as can be seen on the diagram below.

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Supply side policies will either increase the quantity or quality of the factors of production.

 

Disinflation

Disinflation is a decrease in the rate of inflation or slowing of the rate of inflation, for example, if inflation was 2.4% and falls to 2.0%.

 

Deflation

Deflation is a fall in the price level, in other words, the rate of inflation must be a negative number.  Deflation is feared as it is often associated with a weak economy stuck in a recession due to low aggregate demand.

 

Japan has experienced deflation in recent years.

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The Bank of Japan and the government have tried to kick start the economy by reducing interest rates.

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Hyperinflation in Hell, by Yoram Bauman, Ph.D., “the world’s first and only stand-up economist”. I dare you to try and not laugh…

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