International Developments in Accounting ACFI 3217 Dr. Samuel Owusu-Agyei HU 3.40

Inflation

What is inflation? The rate of increase in prices over a given period of time. How much more expensive the relevant set of goods and/or services has become over a certain period, most commonly a year. The value of a currency is observed in terms of purchasing power. Higher inflation  Decline in purchasing power of money. Each pound buys a smaller percentage of a good or service.

What is inflation? Inflation can be used as a broad measure, e.g. overall increase in prices or the increase in the cost of living in a country. To measure the average consumer’s cost of living. Government agencies conduct household surveys to identify a basket of commonly purchased items and then track the cost of purchasing this basket over time. For example, the largest component of the consumer basket in the United States include housing expenses such as rent and mortgages.

What is inflation? The basket varies from country to country. E.g. food can be biggest part of household budgets in a country. The cost of this basket at a given time expressed relative to a base year is the Consumer Price Index (CPI), and the Retail Price Index (RPI). Inflation is measured as an annual percentage increase.

Basic types of inflation Hyperinflation: This is the most extreme inflation phenomenon. It has yearly price increases of three-digits percentage points and an explosive acceleration. Extremely high / high inflation: In extremely high inflation, yearly price could range anywhere between 50% and 100%. In a high inflation situation, prices could increase by about 30%-50% a year. Both could be stable or dangerously accelerate into a hyperinflation condition.

Basic types of inflation Moderate inflation: Can be differently defined around the world, given the different inflation histories. As an indication only, one could consider an inflation as moderate when it ranges from 5% to 25-30%. For some countries, 25%-30% is already "high inflation".

Basic types of inflation Low inflation: can be characterized from 1-2% to 5%. Inflation rate was 2.1% and 2.7% in the US and UK respectively, for the 12 months ended December 2017. Around zero there is no inflation (price stability). Below zero, a country faces deflation.

Hyperinflation

Hyperinflation Prices of most goods and services skyrocket, usually more than 50% a month. Starts when a country's Federal government begins printing money to pay for fiscal spending. Money supply increases, prices creep up as in regular inflation. However, instead of tightening the money supply to lower inflation, the government keeps printing more money to pay for spending.

Hyperinflation Higher inflation rates leads to higher nominal interest rates. In the first phase, nominal interest rates may not keep pace with inflation, as such real interest rates may fall. Without the central bank factoring in inflation, the real interest rates are kept much higher than before. In absence of central bank reaction (to inflation), it is for example common that inflation tends to provoke currency devaluation.

Implications of inflation Inflation makes import cheaper in comparison to domestic products, to the extent that domestic firms face more intense competition, which should brake inflation. With higher inflation, domestic goods are more expensive in an international comparison, typically with a fall in exports and a rise of imports, heavily deteriorating the trade balance. Oftentimes, central banks choose to fix a certain exchange rate target as a nominal anchor in the battle against inflation.

Inflation: Country example Many countries have grappled with high inflation—and in some cases hyperinflation, 1,000 percent or higher inflation a year. For example 2008, Zimbabwe experienced one of the worst cases of hyperinflation ever, with estimated annual inflation at one point of 500 billion percent.

Higher interest rates: UK The main interest rate is set by the Bank of England. It is known as the base rate. If inflation is likely to increase, then the bank may decide to increase interest rates, in order to: reduce demand and reduce the rate of economic growth.

Higher interest rates: UK The Bank of England expects a higher inflation rate of 2.7% for 2018, which is well above its target rate of 2%. The Bank unanimously kept interest rates on hold at a record low of 0.25% to encourage household reduce their savings levels, allowing them to keep spending. Nevertheless, the Bank warned that there were "limits to the degree to which above-target inflation could be tolerated". Interest rates were raised from the 0.25% to 0.5% late 2017

Current Situation- EU According to official statistics, Inflation in the euro zone remained at 0.2% in December 2016, unchanged from November as against 0.3% expected by economists deals. As at December 2017, inflation in the Eurozone was at 1.4% and estimated at 1.3% in January 2018. Price growth in food, alcohol and tobacco estimated at 2.1% in January 2018.

Current Situation- EU The data will put pressure on the European Central Bank to act further to boost the struggling European economy. The European central bank is actively in attempt to improve the economy and achieving price stability. “The economic recovery is continuing but inflation developments remain subdued. So, while we are confident in the recovery, we still need a patient and persistent approach to our monetary policy to ensure that medium-term price stability is achieved”. Mario Draghi, President of the ECB

Deflation

What is deflation? This is the opposite of inflation. When the inflation rate (by some measure) is negative, i.e. inflation falls below zero per cent. An economy is in a deflationary period. Prices are declining over time. As such money is becoming relatively more valuable than the other goods in the economy.

Common features of deflation The supply of money goes down. The supply of other goods goes up. Demand for money goes up. Demand for other goods goes down.

Low Oil Price = Deflation? Low oil price generates very low general inflation in many countries, especially among the developed economies. In the UK, the eurozone, the US and Japan, central banks have an inflation target of 2% and the headline rate is well below that. As long as it's just energy prices that are falling, it's not a major problem.

Low Oil Price = Deflation? However, Central Bankers are wary of the effect of low fuel prices. They expect that inflation is going to be very low or even below zero. This can lead to a damaging spiral of falling prices or deflation. There's a risk that consumers and businesses will delay spending to take advantage of lower prices. Inflation above zero but still very low can have a similar effect.

Low Oil Price = Deflation? It's not generally thought that there is any imminent danger of the UK, the euro zone or the US experiencing that problem. But the central banks are very keen to ensure that they don't. For the most part the cheaper oil is a benefit in most countries. But some - the oil exporters - are exceptions to that rule.

In several nations, the nominal exchange rate was frequently used as a way of bringing down the level of inflation. How is this possible? Next week, we shall consider Foreign Exchange