 Inflation is a sustained increase in the general level of prices Inflation rate is the annual % change in prices  A fall in inflation means that prices are rising but at a slower rate than before.  When prices rise, the real purchasing power of cash declines  Deflation on the other hand is a sustained decrease in general prices

 Inflation has two main causes  Demand – pull inflation  When aggregate demand is rising faster than the ability of the economy to supply goods and services – leading to excess demand  Positive output gap (when actual GDP > Trend GDP)  Businesses respond by raising prices to increase their profit margins  Demand-pull inflation associated with the boom phase of the economic cycle  Cost – push inflation  Occurs when costs of production are increasing  This leads to inward shift in short run aggregate supply  Firms raise prices to protect their profits  Wages often follow prices – if there is an increase in inflation, this may lead to a rise in pay claims – this is known as a wage price spiral

Real National Output Price Level SRAS1 Y1 AD1 P1

Real National Output Price Level SRAS1 Y1 AD1 P1 AD2

Real National Output Price Level SRAS1 Y2 P2 Y1 AD1 P1 AD2

Real National Output Price Level SRAS1 Y2 P2 Y1 A higher level of aggregate demand (e.g. caused by rising consumer spending) puts upward pressure on the price level AD1 P1 AD2

Real National Output Price Level SRAS1 Y1 AD1 P1

Real National Output Price Level SRAS1 Y1 SRAS2 AD1 P1

Real National Output Price Level SRAS1 Y2 P2 Y1 SRAS2 AD1 P1

Real National Output Price Level SRAS1 Y2 P2 Y1 Shifts in AS are caused by changes in input costs – for example a rise in oil prices leads to higher costs and an inward shift of SRAS – and a higher general price level SRAS2 AD1 P1

Earnings Productivity Unit labour costs Import Prices Commodity Prices Taxes Profit Margins inflation Basic Pay Bonuses + overtime Secular Influences (e.g. ICT impact) Economic Cycle Fiscal Policy Global Economic Cycle Exchange rate / Profit margins + = + + +

 Economic costs of inflation depend on  The degree of inflation – more costly when inflation is high  Whether inflation is  Correctly anticipated by consumers and producers  Unanticipated – I.e people’s expectations of inflation turn out to be wrong  Whether inflation in one country is higher than in other countries  Whether the exchange rate adjusts to restore lost price and cost competitiveness for exporters  High and variable inflation usually creates more economic costs than low and stable rates of price inflation  Volatile inflation – diverts resources towards protection from its effects rather than a productive contribution to extra output  We can make a distinction between micro and macro-economic costs of inflation

 Inflation leads to a re-distribution of income and wealth  From lenders to debtors if real interest rates become negative  Away from those on fixed incomes or with weak bargaining power  Loss of international competitiveness (when relative inflation is high)  Impact on exports (loss of market share)  Imports become relatively cheaper (rising import penetration)  Worsening of the international trade performance  Monetary policy response to high inflation –i.e. higher (nominal) interest rates – which has negative effect on real output, investment and employment  Loss of business confidence (lower planned investment) due to uncertainty and lower expected real rates of return on capital  Shoe-leather and menu costs

 Hungary experienced hyperinflation on this scale  1939 Price Index (PI) = 100  Jan 1946 PI = 5,371,300  June 1946 PI = 19,686,163,000,000  A more recent example is Zimbabwe- where due to Hyperinflation the currency became worthless. When this happens, you need an alternative currency, or you end up with a barter economy.

 Policies should focus on the causes of inflation:  Demand-pull inflation:  Requires control of aggregate demand  Aim: reduce the a positive output gap  “Deflationary policies” to reduce real incomes and spending  Cost-push inflation:  Requires policies to control unit costs of production  Policies that stimulate competition and keep prices down in markets and industries  Policies that increase aggregate supply potential in the economy (in particular an increase in LRAS)

 Demand-Pull Inflation  Higher interest rates Increase in direct taxes such as income tax  Cuts in real level of government spending  If the Government runs a Budget Surplus, this is a net withdrawal from the circular flow (helps to reduce AD)  Cost-Push Inflation  Higher exchange rate  Direct controls on wages and prices  Measures to stimulate increased competition  Policies designed to increase labour productivity (AS)

Expansionary Monetary Policy Lower Nominal Interest Rates Stimulates Capital Investment Increase in AD Expansionary Monetary Policy Increased demand for credit Stimulates Consumer Spending Increase in ADExpansionary Monetary Policy Exchange Rate Depreciation Stimulates Net Exports Increase in AD Expansionary Monetary Policy Rise in Equity Prices Rise in Land and House Prices Rise in Value of Financial Wealth Increase in AD INTEREST RATE CHANNEL BANK LENDING CHANNEL EXCHANGE RATE CHANNEL WEALTH EFFECT CHANNEL

 – a return to the low and stable inflation last seen in the 1950s and 1960s  Several factors explain the absence of inflation  Subdued growth of wages and earnings (below 5%)  Absence of major inflationary shocks such as a sharp jump in international commodity prices (although Oil in 2008 could have caused this if it had continued  Success of Central Banks in keeping aggregate demand under control through interest rate changes  Much greater competitive pressure in many industries  Strong pound has helped to keep inflation under control  Expansion of information technology has helped to reduce costs  Cuts in the prices charged by many of the privatised utilities  Expectations of inflation have fallen!

 Low stable inflation can provide a boost to economic growth  Easier for productivity improvements to show through in higher real wages  Gentle rise in prices boosts company earnings and gradually erodes the real value of debt  2-3% inflation gives some scope for relative prices to change in the economy reflecting changes in supply & demand conditions  Price deflation  A fall in the internal price level  Economy-wide deflation is rare but many individual examples exist in specific industries and markets  Farm prices in  House prices in the early 1990s  Coffee prices

 Shift in thinking of economic policy-makers (fearing a return to the inflation of the 1970s and 1980s – widespread adoption of inflation targets)  Decline in inflation expectations. Consumers are now more price conscious - harder to make price increases stick (increase in price elasticity of demand?)  Change in the of the structure of the economy  Declining importance of manufacturing (33% of GDP in 1970 down to 19% in 2000)  Long run decline in trade union membership – less upward pressure on real wages  Impact of deregulation (higher market supply drives prices lower)  Intensity of price competition from the East - massive pool of cheap labour aiming at the "inflationary weak spot of Western nations - manufacturing"!  The information & communication revolution (ICT) - can undermine monopoly power through the costless transmission of price information – but the impact of e-commerce should not be exaggerated