Inflation

Introduction to Inflation

Inflation is a sustained increase in the cost of living or the general price level leading to a fall in the purchasing power of money

• The rate of inflation is measured by the annual percentage change in consumer prices

• The UK government has set an inflation target of 2% using the consumer prices index (CPI)

• It is the job of the Bank of England (BoE) to set monetary policy interest rates so that inflationary pressures are controlled and the inflation target is reached

• A fall in inflation is not the same as a fall in prices! Only when there is deflation will the general price level fall

Inflation – Some Key Terms

Consumer Price Index (CPI)

A measure of the price level in the economy based on the prices of a collection of products designed to reflect the consumption basket of the average consumer

Deflation A decline in the general price level in an economy, signified by an annual inflation rate below 0% (negative).

Disinflation Disinflation is a fall in the rate of inflation e.g. from 5% to 2%. Prices are still rising but at a slower rate.

Hyper-inflation A period of very high rates of inflation, usually leading to a loss of confidence in an economy’s currency.

Inflation rate The annual rate of change of the average price of goods and services.

Unit labour costsReflect total labour costs, including social security and employers’ pension contributions, and including the costs of self-employed labour, incurred in the production of a unit of economic output.

Category in the CPI Weights CPI in June 2014 CPI in June 2015

Food and non-alcoholic beverages 110 143.2 140.1

Alcoholic beverages and tobacco 43 156.5 160.1

Clothing and footwear 70 83.4 82.8

Housing, water, electricity, gas and other fuels 128 154.7 155.4

Furniture, household equipment and maintenance 59 120.9 120.5

Health 25 130.0 132.0

Transport 149 137.6 135.0

Communication 31 112.5 113.7

Recreation and culture 147 102.9 101.9

Education 26 222.2 244.3

Restaurants and hotels 121 132.6 135.1

Miscellaneous goods and services 91 120.3 120.5

Overall consumer price index 1000 128.3 128.2

Weighting the Consumer Price Index in the UK

Limitations of the CPI as a measure of inflation

Few households are average – the published figure for inflation is rarely the actual rate of inflation experienced by different people

1. The CPI is not fully representative - it will be inaccurate for the ‘non-typical’ household, e.g. 14% of the CPI index is devoted to motoring costs - inapplicable for non-car owners.

2. Spending patterns: e.g. Single people have different spending patterns from households that have one or more children

3. Changing quality of goods and services: Although the price of a good or service may rise, this may also be accompanied by improvements in quality / performance of the product

4. New products: The CPI is slow to respond to new products and services – the CPI basket is changed each year but only a few items fall out / come in

The UK Consumer Price Index (CPI) from 2000-2015

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 201580

90

100

110

120

130

140

93.1 94.2 95.4 96.7 98100

102.3104.7

108.5110.8

114.5

119.6123

126.1128 128

Cons

umer

Pric

e In

dex

(200

5=10

0)

Text goes hereInflation is a sustained rise in the general price level e.g. as shown by the annual change in the consumer price index.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

0.8%

1.2% 1.3% 1.4% 1.3%

2.1%2.3% 2.3%

3.6%

2.2%

3.3%

4.5%

2.8%2.6%

1.5%

Infla

tion

rate

CPI inflation target = 2%

Inflation Rate in the UK Economy in Recent Years

A lower inflation rate means prices rise more slowly – this is known as disinflation

CPI Inflation in the UK over the last 20 Years

The inflation rate for goods such as clothing and computing equipment has been, on average, lower than for service such as insurance and education

1995 JAN 1996 SEP 1998 MAY 2000 JAN 2001 SEP 2003 MAY 2005 JAN 2006 SEP 2008 MAY 2010 JAN 2011 SEP 2013 MAY-3

-2

-1

0

1

2

3

4

5

6

7

CPI all items

CPI goods

CPI services

Annual rate of change of consumer prices (%)

UK Inflation Rates in Recent Years

Year UK Consumer Price Inflation

UK Whole Economy Average Earnings

Halifax House Price Inflation

Inflation in the European

Union

Per cent Per cent Per cent Per cent

2011 4.5 2.5 -2.5 3.1

2012 2.8 1.4 -0.6 2.6

2013 2.6 1.2 4.6 1.5

2014 1.5 1.1 8.8 0.6

2015 (April) 0.1 2.7 8.6 0.3

Source: HM-Treasury Databank

The Bank of England’s target is for inflation to be 2%. The Governor of the Bank of England must write an open letter to the Chancellor if inflation is more than one percentage point higher or lower than this target (i.e. more than 3% or less 1%). CPI Inflation has been either above 3% or less than 1% in 25 of 57 months since May 2010.

What are the Main Causes of Inflation?

Demand Pull inflation• Caused by excess aggregate demand• Often linked to a money and credit boom• Economy close to full capacity (inelastic AS)• Positive output gap (AD > potential GDP)

Cost Push Inflation• Rising wage costs in labour market• Increasing raw material and component

costs from domestic and overseas suppliers• Rising import prices due to a falling

exchange rate – this increases import costs

Administered Prices• Changes in regulated prices e.g. water bills• Changes in indirect taxes and subsidies• Changes in environmental taxes

Inflation Expectations

Once inflation becomes established in an economy it can be difficult to remove.

Most agents in the economy (e.g. workers, businesses and lenders) will raise their inflation expectations and build it into their calculations and decisions

A rise in inflation can lead to an increase in inflation expectations. This can then feed through to higher wage claims and rising costs

Some factors affecting inflationary pressures

Rising property prices

Increased consumer wealth

Demand pull inflation risk

Increasing world oil prices

Higher costs for businesses

Cost-push inflation risk

Depreciating exchange rate

Increased import prices + rising

exports

Cost-push and Demand pull inflation risk

Rapid expansion of money and

credit from banks

Rising consumer spending financed

by loans

Demand pull inflation risk

Cost-Push Inflation using AD-AS Diagram

GPL

Real GDP

GPL1

AS1

Y1

AD

AS2

Y2

GPL2

Cost-push inflation occurs when firms respond to rising costs by increasing their prices to protect profit marginsCan be caused by:1. Rising unit labour costs2. Higher prices for

important components/raw materials

3. A depreciation in the exchange rate causing a rise in import costs

4. An increase in business taxes e.g. VAT or environmental taxes such as a carbon tax

Demand Pull Inflation using AD-AS Diagram

GPL

Real GDP

GPL2

AS

Y2

AD2AD1

Y1

GPL1

1. Demand-pull inflation occurs when AD grows at an unsustainable rate leading a positive output gap (i.e. Actual GDP > Potential GDP)

2. When there is excess demand, producers can raise their prices and thereby achieve bigger profit margins

3. Demand-pull inflation is most likely when there is full employment of resources, when aggregate supply is inelastic

Analysis: Internal and External Causes of Inflation

A large surge in property prices

Higher wages / labour costs

Boom in credit / money supply

Rise in business taxes e.g. VAT

Increase in world oil / gas prices

Inflation in global commodity prices

Depreciation of the exchange rate

High inflation in other countries

Internal causes of inflation External causes of inflation

Countries with Highest Inflation in 2015

Venezuela

Ukraine

South Sudan

Belarus

Sudan

Argentina

Russia

Malawi

Islamic Republic of Iran

Sierra Leone

Tajikistan

Eritrea

Ghana

Kyrgyz Republic

Egypt

0.0% 20.0% 40.0% 60.0% 80.0% 100.0% 120.0%96.8%

33.48%

28.98%

22.08%

19.03%

18.65%

17.94%

17.31%

16.5%

13.07%

12.85%

12.26%

12.2%

10.75%

10.26%

Inflation rate (per cent) compared to previous year (March 2015)

Why is High Inflation an Economic Problem?

Many governments target a low but positive rate of inflation. They believe persistently high inflation can have damaging consequences

• Inequality: Inflation has a regressive effect on lower-income families in developed & developing countries – most of their wealth is held in cash

• Falling real incomes – if wage rises lag behind price increases each year

• Negative real interest rates: If the interest on savings is lower than inflation

• Cost of borrowing: High inflation may also lead to higher interest rates for businesses and consumers with debts (e.g. Rising mortgage rates)

• Risks of wage inflation: This leads to rising labour costs and lower profits

• Business competitiveness: A high relative rate of inflation can reduce competitiveness which will lower demand for the country’s exports

• Business uncertainty: High and volatile inflation is not good for confidence partly because businesses cannot be sure of what their costs and prices are likely to be. This uncertainty might lead to a fall in capital investment

Possible Winners and Losers from High Inflation

One of the effects of inflation is that it can lead to arbitrary changes in the distribution of real incomes and wealth in a country

Winners• Workers with strong wage

bargaining power• Debtors if real interest

rates are negative• Producers if prices rise

faster than costs

Losers• Retired on fixed incomes• Lenders if real interest

rates are negative• Savers if real returns are

negative• Workers in low paid jobs

Why is inflation difficult to forecast accurately?

Forecast inflation for UK (source: BoE)

The chart shows the UK CPI inflation forecast published by the Bank of England. The probability fan chart for inflation indicates the range of probabilities for inflation in the forecast period.

Volatile global energy prices

Changes in value of

the currency

Uncertain growth of aggregate demand

Volatile food prices

Government indirect

taxes can change

Macroeconomic Policies to Control Inflation

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)

• Fiscal policy: A tightening fiscal policy would include less spending on public and merit goods or welfare payments or raising direct taxes

• Monetary policy:

• A ‘tightening of monetary policy’ via higher interest rates or a reversal of quantitative easing or tougher controls on bank lending

• Higher interest rates may cause the exchange rate to appreciate bringing cheaper imported goods and services

• Supply side policies to increase productivity, competition and innovation

• Direct controls

• Public sector pay controls e.g. Limiting pay rises for NHS workers

• Capping or other regulation of prices of utilities such as water bills

Deflation

Countries with the lowest inflation rate in 2015

GrenadaSwitzerland

ZimbabweBulgaria

MicronesiaCyprusCroatiaPoland

El SalvadorDominica

SpainMarshall Islands

SloveniaLithuania

Camboadia

-1.8% -1.6% -1.4% -1.2% -1.0% -0.8% -0.6% -0.4% -0.2% 0.0%-1.55%

-1.19%-1.05%-1.03%

-1%-1%

-0.89%-0.83%

-0.8%-0.77%

-0.73%-0.59%

-0.39%-0.31%-0.31%

Inflation rate compared to previous year

Deflation is a persistent fall in a country’s general price level. A number of countries were experiencing negative inflation rates in May 2015 among them a growing cluster of countries inside the European Union.

The Causes of Price Deflation

Deflation is a persistent fall in the general price level of goods and services. The rate of inflation becomes negative.

Demand-side causes of deflation

• Deep fall in AD causing a persistent recession / depression

• Large negative output gap – i.e. high level of spare capacity

Supply-side causes of deflation

• Improved productivity• Technological advances• Significant fall in wage rates• High exchange rate causing

import prices to fallReal GDP

GPL1

AS1

Y1

AD1

AS2

Y2

AD2

GPL2

GPL

Evaluating the Consequences of Price Deflation

1. Holding back on spending: Consumers may postpone demand if they expect prices to fall in the future

2. Debts increase: The real value of debt rises with deflation and higher real debts can be a big drag on consumer confidence

3. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices.

4. Lower profit margins: Lower prices can mean reduced revenues & profits for businesses - this can then lead to higher unemployment as firms seek to reduce costs by shedding labour.

5. Confidence and saving: Falling asset prices such as price deflation in the housing market hits personal sector wealth and confidence

6. Income distribution: Deflation leads to a redistribution of income from debtors to creditors – but debtors may default on loans

7. Deflation can make exporters more competitive eventually – but this often comes at a cost i.e. higher unemployment in short term

Evaluating the Consequences of Price Deflation

Real interest rates rise

Real level of debt rises

Pressure for lower wages

Declining business profits

Rise in cyclical unemployment

Improved price competitiveness

Economic Policies to Avoid Price Deflation

The main approach to avoiding deflation is to use macro-stimulus policies either by loosening monetary policy and/or fiscal policy

Low interest rates and quantitative easing• In some countries, policy interest rates have become negative e.g. Switzerland• Cheaper loans for businesses and households• Expanding the supply of credit in banking system• QE used by many central banks including BoE and European Bank

Fiscal stimulus measures• Higher government spending (e.g. capital projects)• A rise in government borrowing to inject demand into the circular flow• Lower direct taxes to increase disposable income and spending

Other measures to stimulate aggregate demand• Attempts to lower the value of the exchange rate (perhaps via central bank

intervention to sell their currency in the market)• Higher taxes on savings to encourage consumption