Inflation
From WikiTextbook
A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.
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Measuring Inflation
CPI (Consumer Price Index)
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. This excludes housing related items such as council tax and housing costs, for example mortgage interest payments.
RPI (Retail Price Index)
The RPI is a broad basket of goods/services whose price is calculated monthly and which provides a broad measure of the level of inflation.
RPIX
This is the RPI excluding mortgage interest payments. This is because when interest rates are increased to control aggregate demand and inflation, the immediate effect is to increase mortgage interest payments and, therefore, housing costs.
RPIY
RPIY, or the core rate of inflation, excludes indirect taxes and the council tax on the inflation rate. By stripping out the effect of these taxes, the Government can establish the core change of prices within the economy. Cynics would argue that it is just another way of reducing the headline rate.
ULC (Unit Labour Costs)
Unit labour costs comprise wages and salaries including employer contributions to social security per unit of output. It is calculated by dividing labour costs by output
PPI (Producer Price Index)
A measure of changes in wholesale prices.
Other measures
Inflation is a general rise in the prices of goods and services in the UK. Inflation is measured in the UK by the Retail Price Index (RPI) which measures the change in prices of over 600 goods and services. These goods and services form a representative basket, in other words they are supposed to represent what the average family buys each week. In December 2003 the Government announced a new measure of inflation, the Consumer Price Index (CPI), to fall in line with the other European countries.
The main causes of inflation
The rate at which prices have been rising has not been stable over the past thirty years within the British economy. This is evident in the graph shown below.
The graph below illustrates the ever changing inflation rates in the u.k since january 2005.
Demand Pull Inflation
Demand Pull inflation occurs when the aggregate demand in an economy increases above aggregate supply. Inflation occurs as real GDP rises and unemployment falls and is often known as "too much money chasing too few goods". This would not be expected to persist over time as supply would increase as a result of the increase in demand and unless the economy was at full employment inflation would decrease.
Here is a graph to show demand pull inflation:
The main causes of demand Pull Inflation include:
- Rapid growth of household consumption
- Increases in government spending
- Injections of demand from higher exports
The term demand-pull inflation is mostly associated with Keynesian economics.
According to the Keynesian theory the more people are employed by firms, the greater the demand. This increase in demand will cause firms to employ more people to increase output. When eventually unemployment is very low, the economy is reaching full capacity and so rises in demand will only increase price due to lack of supply, leading to inflation
Cost Push Inflation
Cost push inflation occurs when there is a reduction in aggregate supply. This inflation is bad news as it means that real national income will fall and prices will rise. This is shown on the graph below:
The main causes of cost push inflation are:
- Rising imported raw material costs
- Rising labour costs
- Higher indirect taxes imposed by the government
- Rising input costs
Monetary Inflation
The monetarist explanation of inflation operates through the Fisher equation.
M.V = P.T
M = Money Supply V = velocity of circulation P = Price level T = Transactions or Output
There is a direct relationship between the growth of the money supply and inflation as Monetarists assume that V and T are fixed. The mechanisms by which excess money might be translated into inflation are examined below.
Individuals can also spend their excess money balances directly on goods and services. This has a direct impact on inflation by raising aggregate demand. The more inelastic in aggregate supply in the economy, the greater the impact on inflation.
The increase in demand for goods and services may cause a rise in imports. Though this leakage from the domestic economy reduces the money supply, it also increases the supply of pounds on the foreign exchange market thus applying downward pressure on the exchange rate. This may cause imported inflation.
If excess money balances are spent on goods and services, the increase in the demand for labour will cause a rise in money wages and unit labour costs. This may cause cost-push inflation.
Costs and effects of inflation
It is agreed that high and volatile inflation has a great affect on consumers, individual businesses and the economy as a whole. However there is still disagreement amongst economists as to the degree of damage that can potentially be done.
Below is a list of some of the possible economic and social costs associated with continuous inflation.
Effect on the U.K competitiveness
- If higher inflation than the rest of the world, it will lose price competitiveness. (assumes given exchange rate)
- If exchange rate depreciates then it may help to restore some of the lost competitiveness. :)
- Inflation in Britain has always generally been higher than other countries.
- Rise in relative inflation leads to a fall in world share of U.K exports and a rise in import penetration. This leads to a fall in economic growth and the level of employment.
Problems of the wage-price spiral
- Price rises can lead to higher wage demands as people need more money to maintain their real standard of living.
- Higher wages above the increase in labour productivity leads to labour costs going up.
- To maintain their profit margins companies increase prices.
- Process could start all over again and the inflation may get out of control. It can take time to for these to be controlled, this could cause an outward shift in the Philips curve.
Inflation can also cause a reduction in the real value of savings.
Especially if real interest rates are negative.
- The rate of interest doesn?t fully compensate for the increase in general price.
- But borrowers see the real value of their debt diminish
- Therefore inflation borrowers at the expense of savers.
- Consumers and businesses on fixed incomes will lose out.
- Many pensioners have fixed pensions this means that inflation reduces the real value of their money.
- The state pension is usually increased each year in line with average inflation.
Inflation can be bad for businesses because:
- Their costs will rise because the amount they have to pay for goods will go up;
- Their sales may fall as consumers will not want to buy as much because the prices have gone up.
- Exports will fall as UK prices rise in comparison to other countries' prices.
- Inflation can also cause a disruption of business planning; uncertainty about the future makes planning difficult and this may reduce the level of investment.
- Budgeting becomes a problem as businesses become unsure about what will happen to their costs.
It is possible that some businesses will benefit from inflation as consumers carry on buying their good or service at the higher price. This will lead to an increase the business revenue.
See also
Statistics
Videos
Why price stability matters - a film by the European Central Bank
The Financial Times explains the impact of the Central Bank on the rate of interest and inflation
Prof. Mankiw's video about printing too much money
Links
Prof Mankiw's PowerPoint presentation
Governor's letter re: missing target 16.4.07
Selected further reading
11.7.07 The Independent Inflation Expectations and Inflation Forecasting - Remarks by Chairman of the US Federal Reserve Ben S. Bernanke
12.1.07 The Independent Jeremy Warner's Outlook: The Bank's been asleep on the job. Surprise of yesterday's rise shows it is awake again
12.1.07 The Independent Shock as Bank lifts rates to 5.25%
12.1.07 The Times City stunned as Bank raises base rate to keep the lid on inflation
19.11.2006 The Telegraph "Friedman is dead, monetarism is dead, but what about inflation?" - editorial on the history and state of inflation
Other revision material
Latest news
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 Reuters South Africa | UK factory inflation hits 14-month high Telegraph.co.uk Consumer prices inflation, the official measure of inflation in the UK is currently at 3.5pc, significantly higher than the 2pc target. ... UK Producer Prices Jump UK producer prices rise more than 4 per cent UK input price annual inflation 6.9% February v 7.7% January |
