1.5 INFLATION & DEFLATION
This video is relevant for this section despite it saying that it is for AQA.
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Inflation is the increase in the price level over a period of time. It is usually measured over the period of a year. Inflation erodes the purchasing power of money, as a given amount of money is unable to buy as much as it used to. Inflation is measured by the annual percentage change in consumer prices. Inflation is when prices are rising. When prices are falling we have deflation. Disinflation is where there is a decreasing level of inflation. For example inflation was 2% and now it is 1%, this is disinflation.
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There are two ways to work out the inflation rate in the UK and they are the Retail Price Index (RPI) and the Consumers Price Index (CPI). The CPI is a weighted average on what consumers spend their money on. Over time, these weights change depending on consumer spending habits. If consumers spent more on food, then the weight for food would increase. Whereas the RPI is an arithmetic mean, meaning that all prices are included.
The UK government has given the Bank of England the aim of making inflation around 2% per annum. The Bank of England is an independent institution from the government and they control the monetary policy for the UK. If inflation is +/- 1 from the target then they have to write an open letter to the government explaining why inflation is away from target and what they expect inflation to be in the future. The Bank of England has to use pre-emptive policies to reach its target inflation, as there is usually a lag of around 18 to 24 months before the policy affects the economy. They have to predict the state of the global economy and predict what shocks the future may bring.
The UK government has given the Bank of England the aim of making inflation around 2% per annum. The Bank of England is an independent institution from the government and they control the monetary policy for the UK. If inflation is +/- 1 from the target then they have to write an open letter to the government explaining why inflation is away from target and what they expect inflation to be in the future. The Bank of England has to use pre-emptive policies to reach its target inflation, as there is usually a lag of around 18 to 24 months before the policy affects the economy. They have to predict the state of the global economy and predict what shocks the future may bring.
Sources of Inflation
We have two sources of inflation, cost-push and demand-pull.
We have two sources of inflation, cost-push and demand-pull.
Cost-Push Inflation
Cost-push is where there is an increase in a factor of production which firms use. An example would be oil. If there was a large increase in the oil price, production would become more expensive for firms. This causes the SRAS curve to shift to the left. There is now a new equilibrium whereby prices are higher than before (inflation) and there is less output being produced both for the classical and Keynesian view of the economy.
Cost-push is where there is an increase in a factor of production which firms use. An example would be oil. If there was a large increase in the oil price, production would become more expensive for firms. This causes the SRAS curve to shift to the left. There is now a new equilibrium whereby prices are higher than before (inflation) and there is less output being produced both for the classical and Keynesian view of the economy.
There are a wide range of reasons for cost push inflation:
- Changes in commodities price. Commodities are traded globally and changes in world commodity prices will affect domestic inflation. During 2014 and 2015 commodity prices have fallen dramatically, especially oil. This has led to inflation in the UK reaching zero, which is well below the 2% target. However, in 2008/09 oil prices were at record levels and inflation in the UK was just above 5%, and this was largely explained by the price of oil but other commodities played a role.
- A fall in the exchange rate. If the exchange rate falls, then this makes imports more expensive. As many resources are imported, if they become more expensive, then this increases the cost of production for firms and this cost increase is passed onto consumers through higher prices.
- Increases in factor of production costs. The main increase would be labour costs. Wage increases greater than the increase in productivity will cause cost-push inflation. Rising rents will also increase the inflation rate.
- Expectation of future inflation. If economic agents expect future inflation to be higher, then it is a self-fulfilling prophecy and inflation will become higher. This can cause a second round of inflation where workers seeing the purchasing power of their income being reduced and then ask for wage rises. This increases the cost of production for firms, which adds to additional cost-push inflation and this can be an upwards spiral all caused by a shock to the economy.
- Higher indirect taxes. If the government chooses to increase its indirect taxes on certain goods, firms may choose to pass these increases onto consumers.
Demand-Pull Inflation
Demand-pull inflation occurs when increases in the level of aggregate demand lead to increased pressure on scarce resources. According to the classical view of the economy, this increase in the level of aggregate demand can result in a positive output gap in the short run, but in the long run output moves back to the long run rate and the price level is even higher. For the Keynes view the increase in aggregate demand increases output and also raises the price level.
Demand-pull inflation occurs when increases in the level of aggregate demand lead to increased pressure on scarce resources. According to the classical view of the economy, this increase in the level of aggregate demand can result in a positive output gap in the short run, but in the long run output moves back to the long run rate and the price level is even higher. For the Keynes view the increase in aggregate demand increases output and also raises the price level.
Demand-pull inflation can be accommodated by an increase in the productive potential of the economy, if supply grows at the same/ or greater rate than demand then an economy will experience inflation. However, if the supply side does not increase, then increases in AD will cause inflation. Below are two increases in the capacity of the economy. Both of these increases in the productive capacity of the economy are able to satisfy a greater level of demand with out a change in the price level.
There are many reasons for demand-pull inflation. Any positive effect on demand can cause inflation:
- Monetary or fiscal stimulus.
- Increase in confidence. If economic agents are confident, then consumption and investment will be strong causing AD to increase.
- Fast growth in other countries. If other countries are experiencing growth then they may suck in imports. This may pave the way for exports for a domestic country and, as exports are a component of AD, an increase in exports, increases AD.
- Depreciation in the exchange rate. If a country’s exchange rate falls, it makes its goods relatively cheap compared to other countries. As your goods are cheaper, the amount of exports increases. Also, a depreciation of your currency, makes other countries goods more expensive. Consumers and firms will switch from foreign goods to domestic goods, which decreases imports (a leakage) and increases domestic demand.