Author: Geoff Riley Last updated: Sunday 23 September, 2012
Overview of the factors influencing the rate of inflation
The diagram below summarises some of the key influences on inflation. Reading from left to right:
Average earnings comprise basic pay + income from overtime payments, productivity bonuses and other supplements to earned income.
Productivity measures output per person employed, or output per person hour. A rise in productivity helps to keep unit costs down.
The growth of unit labour costs is a key determinant of inflation in the medium term.
Additional pressure on prices comes from higher import prices, commodity prices (e.g. oil, copper and aluminium) and also the impact of indirect taxes such as VAT and excise duties.
Prices also increase when businesses decide to increase their profit margins. They are more likely to do this during the upswing phase of the economic cycle. Conversely inflationary pressures decline in a recession when businesses have far more spare capacity and may decide to offer deep price discounts to their customers to get rid of unsold stock.
Rising expectations of inflation can be self-fulfilling
If people expect prices to continue rising, they are unlikely to accept pay rises less than their expected inflation rate because they want to protect the purchasing power of their incomes
When workers are looking to negotiate higher wages, there is a danger of a ‘wage-price spiral’ that then requires the introduction of deflationary policies such as higher interest rates or an increase in direct taxation.
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