INFLATION THE UK ECONOMY (MACROECONOMICS) TOPIC 2

INFLATION  Inflation is a rise in the general level of prices.  This does not mean that all prices rise, some may rise, others fall or stay the same.  The Rate of Inflation is the percentage increase in the general rise in prices.

HOW IS IT MEASURED? 3 ways to measure inflation: 1.Retail Price Index (RPI) – this is also called the HEADLINE RATE OF INFLATION The RPI is a weighted average of the prices of the goods and services most commonly bought by households.

 The Family Expenditure Survey is used to identify a basket of products bought by the majority of households.  Each item is weighted according to the amount of spending on it. E.g. if 5% of consumer spending was on petrol, then price would have a weighting of 5%.  A point in time is chosen as the base year.  Each month the price of each item is compared and expressed as a percentage of its price at the base date. This is called a PRICE RELATIVE.  This is calculated by taking the current price dividing it by the base price and multiplying by 100.  E.g. price was 50p at the base year and is now 70p, the price relative would be 140

 The price relative is the multiplied by its weighting and then included in the index. E.g. 140x5% = 7.  This is repeated for each item and the figures are added to give the weighted average total.  The RPI at the base date is 100.

HOW IS IT MEASURED? 2.Retail Price Index Excluding mortgage interest payments (RPIX)– also called the UNDERLYING RATE OF INFLATION This, until 2004, was the main measure of inflation. It was RPIX that the government used as its inflation target for the Bank of England and the monetary policy committee (MPC) The target use to be 2.5% based on RPIX

 RPIX was felt to be a better measure of inflation because it took out mortgage interest payments.  One of the main instruments to control inflation is to increase interest rates as it reduces inflation.  However, increasing interest rates makes mortgage costs increase and therefore increases RPI.  So taking that out gave the government a better idea of how anti-inflation policy was working.

HOW IS IT MEASURED? 3.Consumer Price Index (CPI) – RPI without housing costs or council tax costs. Since 2004 this has been the government’s official measure for inflation. Its full name is the HARMONISED INDEX OF CONSUMER PRICES, but more often referred to as the CONSUMER PRICE INDEX.

 The main reason the UK switch to this method is that it is much closer to the method used by the rest of the EU.  This makes it easier to compare inflation rates with the rest of the EU.  CPI is calculated each month by taking the current index minus the last index and multiplying by the last index.  The current target for the Bank of England for inflation is 2% based on CPI.  PLEASE NOTE THAT A FALL IN THE RATE OF INFLATION DOES NOT MEAN A FALL IN PRICES JUST THAT PRICES ARE RISING AT A SLOWER RATE.

EFFECTS OF INFLATION THE UK ECONOMY (MACROECONOMICS) TOPIC 2

ON INDIVIDUALS  Reduces the standard of living of people  real income fall.  Disposable income of people on low wages may be reduced  An increase in their money wage which arises from inflation could result in them paying income tax. This is called FISCAL DRAG  It causes unemployment.  Reduced competitiveness, firms lay off staff so they remain competitive.  It reduces the real value of savings if the interest rate is less than the rate of inflation.  Real Rate of Interest = Nominal Rate of Interest – Rate of Inflation.

But even with the purchasing power of savings falling people still save for a number of reasons:  They do it out of habit  They are contracted in for long periods  In order to buy products  People are ignorant of the effects of inflation

ON FIRMS  Inflation reduces the real value of profits of firms  Foreign firms with low inflation can keep prices low  It reduces the willingness to invest.  Inflation creates uncertainty in an economy about future prices and profits.  It can encourage inefficiency.  If firms operate in markets with little competition they can mask inefficiency by increasing prices, but blaming inflation.

ON THE ECONOMY  The Balance of Payments may deteriorate.  makes exports more expensive to foreign buyers and imports will be cheaper for domestic buyers.  It reduces economic growth because firms are unwilling to invest  It distorts the balance of taxation.  The balance between direct and indirect taxation may be distorted.  A period of inflation creates an expectation of inflation which creates inflation.  This means if workers expect inflation to be 2% then they will demand a 2% increase in wages and so on…  Threatens the use of money  hyperinflation

ADVANTAGES OF INFLATION  Borrowers gain from inflation.  The money they borrowed has less purchasing power now but they used it when it had better purchasing power.  Some firms are able to increase prices and therefore profits before they give out higher wages.  The government finds that people earn more and so pay more tax.

CAUSES OF INFLATION THE UK ECONOMY (MACROECONOMICS) UNIT 2

KEYNESIAN APPROACH  Keynesians believe that there are 3 causes of inflation. 1.Demand-pull inflation This type of inflation happens when the economy is in boom. Aggregate demand is greater than full employment output and so prices rise. e.g. South-East DEMAND IS PULLING UP PRICES RESULTING IN INFLATION!

KEYNESIAN APPROACH 2.Cost-push inflation This occurs when the cost of production increases at a faster rate than productivity. It leads to increases in unit costs. Reasons for cost increases:  Increases in cost of raw materials  Increases in the price of energy  Increases in wages  Fall in the exchange rate of sterling which increases the price of any imported materials and energy.

KEYNESIAN APPROACH 3.Expectations of Inflation REMEMBER – If people expect inflation they will demand more in wages which results in the expected inflation. Sometimes called WAGE-PRICE SPIRAL and inflation becomes a permanent feature of an economy.

MONETARISM  Monetarists believe that inflation is caused an excessive growth in the money supply.  If these growths are greater than increases in output it will lead to increased prices.  Monetarism was developed by an economist called Milton Friedman

MONETARISM  The theory states that:  MV = PQ  M = the money supply  V = the velocity of circulation, this is the number of purchases in a year.  P = the price level  Q = the quantity of output per period.  Monetarist believe that V is stable and does not change.  Any increase in M which is greater than Q will lead to an increase in P which leads to inflation.

WHAT IS THE MONEY SUPPLY?  Money consists of:  Notes  Coins  Bank deposits

INCREASES IN THE MONEY SUPPLY There are two major causes: 1.Bank lending.  Banks make their money on the interest they charge on loans. Therefore banks will lend as much as they possibly can. 2.Government borrowing.  Governments sometimes spend more than they take in from taxes and so have to borrow. Monetarists believe that once inflation is in an economy then expectations of inflation causes more inflation. Same as Keynesians.

INCREASES IN THE MONEY SUPPLY  Monetarists see demand-pull and cost-push as symptoms rather than causes of inflation since both are a result of excessive growth in the money supply.  Demand-pull is a result of too much credit being given customers and firms  Cost-push is a result of firms borrowing to cover increased costs and then increasing prices to cover borrowing costs.

INFLATION RECORD   The UK economy was in recession. This helped reduce inflation as aggregate demand was reduced.  1993 – 2000  Recovery started in 1993 but did not have the usual increase in inflation apart from slight rises in 1995 and  There are a number of reasons for this:  Pay awards have been low  Low increases in imported raw materials  Ability to raise prices limited due to low inflation elsewhere  Tight control by the government and since 1997 the Monetary Policy Committee of the Bank of England.

DEFLATION  This is a fall in the general level of prices.  This is not good for an economy.  Falling prices occur because of falling demand. This makes it difficult for firms to make profits and can lead to labour being paid off.  Falling share prices and house prices reduce people’s wealth. Creates a “feelbad” factor, this reduces consumer confidence.  The real value of debts increase. This makes it harder for borrowers to repay.  Japan had been recently experiencing deflation.