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AS Macroeconomics / International Economy

Inflation

What causes rising prices in an economy? And what tools are available to keep inflation under control? This chapter focuses on the causes of inflation and some of the consequences.

What is inflation?

Inflation is best defined as a sustained increase in the general price level leading to a fall in the purchasing power or value of money. The greatest falls in the value of money came during the mid-late 1970s and again in the late 1980s when there was acceleration in the rate of inflation in the UK. In contrast, the last fifteen years have seen much lower rates of inflation – and as a result, money has held value better. The next chart shows the UK consumer price index since 1970.

The value of money refers to the amount of goods and services £1 can buy and is inversely proportionate to the rate of inflation. Inflation reduces the value of money. When prices are increasing, then the value of money falls.

The rate of inflation is measured by the annual percentage change in the level of consumer prices. The British Government has set an inflation target of 2% using the consumer price index (CPI). It is the job of the Bank of England to set interest rates so that AD is controlled and the inflation target is reached. Since the Bank of England was made independent, inflation has stayed comfortably within target range. Indeed Britain has one of the lowest rates of inflation inside the EU.

There has been a fall in average inflation rates in most of the world’s developed countries including the UK over the last fifteen years.  Indeed lower inflation seems to have become a global phenomenon. Japan has experienced negative inflation (i.e. price deflation) over recent years (although in 2006, this period of price deflation came to an end) and the German economy has also come close to experiencing deflation with inflation of less than one per cent.

Deflation

Price deflation is when the rate of inflation becomes negative. I.e. the general price level is falling and the value of money is increasing. Some countries have experienced deflation in recent years – good examples include Japan and China. In Japan, the root cause of deflation was slow economic growth and a high level of spare capacity in many industries that was driving prices lower.  In China, economic growth has been rapid – but the huge amount of capital investment and rising productivity has led to economies of scale being exploited and a fall in production costs.

There has been some price deflation in the UK economy – not for the whole economy – but for items such as clothing (where many prices of clothing on the high street have been driven lower by cheaper imports); audio-visual equipment, computers and many other household goods. The effects of technological change in increasing supply are important when explaining deflation in some UK markets. Rapid advances in technology help to explain for example the sharp fall in the prices of state of art digital cameras and televisions, which has made the digital age accessible to millions of consumers.

Hyperinflation

A 500 billions bill with most zeros in the economy history. The product of hyperinflation in Yugoslavia 1993

Hyperinflation is extremely rare. Recent examples include Yugoslavia Argentina , Brazil , Georgia and Turkey (where inflation reached 70% in 1999). The classic example of hyperinflation was of course the rampant inflation in Weimar Germany between 1921 and 1923 . When hyperinflation occurs, the value of money becomes worthless and people lose all confidence in money both as a store of value and also as a medium of exchange. The current hyperinflation in Zimbabwe is a good example of the havoc that can be caused when price inflation spirals out of control.

Often drastic action is required to stabilize an economy suffering from high and volatile inflation – and this leads to political and social instability. The International Monetary Fund is often brought into the process of implementing economic reforms to reduce inflation and achieve greater financial stability.

The main causes of inflation

Inflation can come from several sources: Some come direct from the domestic economy, for example the decisions of the major utility companies providing electricity or gas or water on their prices for the year ahead, or the pricing strategies of the leading food retailers based on the strength of demand and competitive pressure in their markets. A rise in government VAT would also be a cause of increased domestic inflation because it increases a firm’s production costs.

Inflation can also come from external sources, for example an unexpected rise in the price of crude oil or other imported commodities, foodstuffs and beverages. Fluctuations in the exchange rate can also affect inflation – for example a fall in the value of sterling might cause higher import prices – which feeds through directly into the consumer price index.

We make a simple distinction between demand pull and cost push inflation.

Demand-pull inflation

Demand-pull inflation is likely when there is full employment of resources and aggregate demand is increasing at a time when SRAS is inelastic. This is shown in the next diagram:

In the diagram above we see a large outward shift in AD. This takes the equilibrium level of national output beyond full-capacity national income (Yfc) creating a positive output gap. This would then put upward pressure on wage and raw material costs – leading the SRAS curve to shift inward and causing real output and incomes to contract back towards Yfc (the long run equilibrium for the economy) but now with a higher general price level (i.e. there has been some inflation).

The main causes of demand-pull inflation

Demand pull inflation is largely the result of the level of AD being allowed to grow too fast compared to what the supply-side capacity can meet. The result is excess demand for goods and services and pressure on businesses to raise prices in order to increase their profit margins.

Possible causes of demand-pull inflation include:

1. A depreciation of the exchange rate which 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 – and there may be a multiplier effect on the level of demand and output
2. Higher demand from a fiscal stimulus e.g. via a reduction in direct or indirect taxation or higher government spending.  If direct taxes are reduced, consumers will have more disposable income causing demand to rise. Higher government spending and increased government borrowing feeds through directly into extra demand in the circular flow
3. Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand – for example in raising demand for loans or in causing a sharp rise in house price inflation
4. Faster economic growth in other countries – providing a boost to UK exports overseas. Export sales provide an extra flow of income and spending into the UK circular flow – so what is happening to the economic cycles of other countries definitely affects the UK

Cost-push inflation

Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit margins. There are many reasons why costs might rise:

1. Component costs: e.g. an increase in the prices of raw materials and other components used in the production processes of different industries. This might be because of a rise in world commodity prices such as oil, copper and agricultural products used in food processing
2. Rising labour costs - caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low (skilled workers become scarce and this can drive pay levels higher) and also when people expect higher inflation so they bid for higher pay claims in order to protect their real incomes. Expectations of inflation are important in shaping what actually happens to inflation!
3. Higher indirect taxes imposed by the government – for example a rise in the specific duty on alcohol and cigarettes, an increase in fuel duties or a rise in the standard rate of Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers

Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. The fall in SRAS causes a contraction of national output together with a rise in the level of prices.

Which government policies are most effective in reducing inflation?

Most governments now give a high priority to keeping control of inflation. It has become one of the dominant objectives of macroeconomic policy.

Inflation can be reduced by policies that (i) slow down the growth of AD or (ii) boost the rate of growth of aggregate supply (AS). The main anti-inflation controls available to a government are:

1. Fiscal Policy: If the government believes that AD is too high, it may reduce its own spending on public and merit goods or welfare payments. Or it can choose to raise direct taxes, leading to a reduction in disposable income. Normally when the government wants to “tighten fiscal policy” to control inflation, it will seek to cut spending or raise tax revenues so that government borrowing (the budget deficit) is reduced. This helps to take money out of the circular flow of income and spending
2. Monetary Policy:A tightening of monetary policy involves higher interest rates to reduce consumer and investment spending. Monetary policy is now in the hand of the Bank of England –it decides on interest rates each month.
3. Supply side economic policies: Supply side policies include those that seek to increase productivity, competition and innovation – all of which can maintain lower prices.

The most appropriate way to control inflation in the short term is for the British government and the Bank of England to keep control of aggregate demand to a level consistent with our productive capacity. The consensus among economists is that AD is probably better controlled through the use of monetary policy rather than an over-reliance on using fiscal policy as an instrument of demand-management. But in the long run, it is the growth of a country’s supply-side productive potential that gives an economy the flexibility to grow without suffering from acceleration in cost and price inflation.

Why has inflation remained low in the UK over recent years?

The last twelve years has been a period of very low and stable inflation. No one factor explains this – but among them we can highlight the following:

1. Low wage inflation from the labour market: Wages have been growing at a fairly modest rate in recent years despite a large fall in unemployment. This has been helped by a fall in expectations of inflation
2. Low global inflation and deflation in some countries: There has been a clear fall in the average rate of consumer prices inflation among leading economies, and this decline in global inflation has filtered through to the UK. World inflation has stayed low despite the recent increases in the prices of many of the world’s globally traded commodities.
3. The effectiveness of monetary policy in the UK: The success of the Bank of England through monetary policy in keeping aggregate demand under control through interest rate changes
4. Increased competition: Many markets have become more contestable in the last decade and this extra competition has placed a discipline on businesses to control their costs, reduce profit margins and seek improvements in efficiency. Many UK businesses face severe pressure from foreign competition as the process of globalisation continues
5. The strength of the exchange rate: The recent strength of the pound has lowered the cost of imported products and also squeezes demand for UK exporters
6. Information technology effects: The rapid expansion of information and communication technology has helped to reduce costs and has made prices more transparent for consumers – e-commerce has contributed to falling prices in many markets

In short, low inflation is the result of a combination of demand and supply-side factors.