Inflation and Deflation

Learning objectives To be able to define and distinguish between inflation and deflation To be able to appreciate how inflation is measured To understand the basics of how inflation is calculated To be introduced to the two main causes of inflation

The meaning of inflation Inflation is defined as a sustained general rise in prices. A general rise in prices may be quite moderate. Creeping inflation would describe a situation where prices rose a few per cent on average each year. Hyper inflation on the other hand, describes a situation where inflation levels are very high. There is no figure at which inflation becomes hyper-inflation, but inflation of 1000 per cent per annum would be deemed to be hyper-inflation by most economists

Hyperinflation in Zimbabwe http://news.bbc.co.uk/1/hi/world/africa/7534190.stm Say ‘stop’ when you hear the figure quoted for Zimbabwe’s rate of inflation. (You will probably think ‘did I hear that right’?)

Disinflation Disinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services over time. Disinflation occurs when the increase in the price level slows down from the previous period when the prices were rising. Disinflation is the reduction in the general price level in the economy but for a short period of time. Disinflation takes place when an economy is suffering from recession.

Deflation Deflation is a sustained decrease in the general price level (after Inflation drops below zero percent) resulting in a sustained increase in the real value of money and other monetary items. Money and other monetary items are worth more all the time during deflation as opposed to being worth less all the time during inflation. Deflation is negative inflation.

Disinflation or Deflation

Measuring inflation RPI – Retail Price Index. Used to measure the average change of prices of goods and services consumed by most households month to month. CPI – Consumer Price Index. The RPI but excludes mortgage payments, buildings insurance, estate agent and conveyancing fees.

Measuring inflation Calculating a price index requires a representative range of goods and services (basket of goods) to be recorded on a regular basis. A typical basket of goods

Rate of inflation on base year Rate of inflation on previous year Measuring inflation The inflation rate is the change in average prices in any given period of time. The price level is measured in the form of an index (an index of 100 today and 121 after 9 years would give a rate of inflation of 21%. In the UK, the most widely used measure of the price level is the Retail Price Index (RPI). Year Index Rate of inflation on base year Rate of inflation on previous year 2000 100 n/a 2009 121 21% 2010 122 22% 4.76% 2011 124 24% 9.09%

Measuring inflation In theory, each month, on the same day of the month, The Office of National Statistics record 110,000 prices for 600 separate goods and services in 146 areas throughout the country different types of retail outlets, such as comer shops and supermarkets. The final ‘basket of goods’ contains 600 goods and services relevant to U.K consumers. These results are averaged out to find the average price of goods and services and this figure is converted into index number form.

Consumer expenditure survey UK, 2014 COICOP category £ per week % of total expenditure Transport   Housing (net)1, fuel and power Recreation and culture Food and non-alcoholic drinks Restaurants and hotels Miscellaneous goods and services Household goods and services Clothing and footwear Communication Alcoholic drinks, tobacco and narcotics Education Health Total COICOP expenditure 461.20 87 Other expenditure items 70.10 13 Total expenditure 531.30 100 Source: Office for National Statistics, Family Spending 2014 1. Excluding mortgage interest payments, council tax for households in Great Britain and domestic rates for households in Northern Ireland. 2. Totals may not add up due to the independent rounding of component categories.

Consumer expenditure survey UK, 2014 COICOP category £ per week % of total expenditure Transport 74.80 14 Housing (net)1, fuel and power 72.70 Recreation and culture 68.80 13 Food and non-alcoholic drinks 58.80 11 Restaurants and hotels 42.50 8 Miscellaneous goods and services 40.00 Household goods and services 35.40 7 Clothing and footwear 23.70 4 Communication 15.50 3 Alcoholic drinks, tobacco and narcotics 12.30 2 Education 9.80 Health 7.10 1 Total COICOP expenditure 461.20 87 Other expenditure items 70.10 Total expenditure 531.30 100 Source: Office for National Statistics, Family Spending 2014 1. Excluding mortgage interest payments, council tax for households in Great Britain and domestic rates for households in Northern Ireland. 2. Totals may not add up due to the independent rounding of component categories.

Calculating inflation and weighted averages In order to calculate a weighting, it is necessary to find out how money is spent. In the case of the Retail Price Index, the weighting is calculated from the results of the Family Expenditure Survey. Each year, a few thousand households are asked to record their expenditure for one month. From these figures it is possible to calculate how the average household spends its money. (This average household, of course, does not exist except as a statistical entity.)

Calculating inflation and the importance of weighted averages Consider a two product economy consisting of food and tobacco Changes in the price of food are more important than changes in the price of tobacco. This is because a larger proportion of total household income is spent on food than tobacco. Therefore the figures have to be weighted before the final index can be calculated.

Calculating inflation and weighted averages Assuming there are only two goods in the economy, food and tobacco, household spending is split 75% on food and 25% on tobacco. Take an increase in the price of food of 8% and of tobacco of 4%. In a normal average calculation, the 8% and the 4% would be added together and the total divided by 2 to arrive at an average price increase of 6%. This provides an inaccurate figure because spending on food is more important in the household budget than spending on tobacco. The figures have to be weighted. Food is given a weight of ¾(or 0.75) and tobacco a weight of ¼ (or 0.25).

Calculating inflation and weighted averages The average increase in food prices of 8% when weighted is actually 6% ([8 % X ¾] The average increase in tobacco prices of 4% when weighted is actually 1% [4% X ¼] The average increase in prices of 6% when weighted is actually 7% i.e. 6 % + 1%. If the RPI were 100 at the start of the year, it would be 107 at the end of the year.

Calculating inflation and weighted averages http://www.ons.gov.uk/ons/rel/family-spending/family-spending/family-spending-2011-edition/sum-family-spending-podcast.html

Demand pull inflation Cost push inflation Money inflation Causes of inflation Demand pull inflation Cost push inflation Money inflation

‘Too much money, chasing too few goods.’ Demand pull inflation ‘Too much money, chasing too few goods.’

The causes of inflation – demand pull inflation The demand-pull theory of inflation says that inflation will result if there is too much money chasing too few goods in the economy. Inflation is therefore caused by excessive spending by households on consumption, by governments on public spending or by foreigners on exports. This approach to inflation is chiefly associated with the economist John Maynard Keynes. Demand pull inflation is most likely to occur at the _________stage of the economic cycle and build as an economy passes the _________rate of growth. During such periods, the output of goods and services from firms cannot keep up with the levels being consumed. Scarcity in the four factors of production (__________, ____________, __________, ______________) means their price is ‘bided’ up. http://www.youtube.com/watch?v=j5-fWsbF8p8

Demand pull inflation can be illustrated as follows.

‘Rising costs of production which are passed onto consumers.’ Cost push inflation ‘Rising costs of production which are passed onto consumers.’

The causes of inflation – cost push inflation A second Keynesian theory of inflation is the cost-push theory of inflation. This states that inflation is caused by increases in costs of production. There are four major sources of increased costs. Wages and salaries. They account for about 70 per cent of national income and hence increases in wages are normally the single most important cause of increases in costs of production. Imported goods. An increase in the price of finished manufactured imports, such as television sets or cars, will lead directly to an increase in the price level. An increase in the price of imported semi-manufactured goods and raw materials, used as component parts of domestically produced manufactured goods, will feed through indirectly via an increase in the price of domestically produced goods. http://www.bbc.co.uk/news/business-12476721 http://www.bbc.co.uk/learningzone/clips/inflation-in-india/11908.html Profits. Firms can raise their prices to increase their profit margins. The more price inelastic the demand for their goods, the less will such behaviour result in a fall in demand for their products. This may be pursued in times of growth. Taxes. Government can raise indirect tax rates such as VAT .These are often regarded as a 'hidden' tax. http://www.bbc.co.uk/news/business-12258328

Cost push inflation can be illustrated as follows.

‘excessive growth of the money supply.’ Money inflation ‘excessive growth of the money supply.’

The causes of inflation – the quantity theory of money Devised by Irving Fishcer in the early 20th century. A theory that suggests the money supply and the price level are linked, known as the Fischer equation. MV Ξ PT M (the money supply), V (velocity of circulation), P (the price level) and T (the number of transactions/output/GDP).

Using the Fischer equation(MV = PT) 1000*5 = ?* 2000 5000/? = 2000 2.5 P=2.5 M = 1200 V= 5 P= ? T= 2000 1200*5 = ? * 2000 6000/? = 2000 6000/2000 = 3 Increasing the money supply is said to lead to an increase in inflation if not matched by an increase in demand. http://www.youtube.com/watch?v=WI1i5yhwOz8

What is quantatative easing (QE)

Will quantatative easing lead to money inflation?