1. Inflation

2. 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

3. 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 costs Reflect 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.

4. Category in the CPIWeights CPI in June 2014 CPI in June 2015 Food and non-alcoholic beverages110143.2140.1 Alcoholic beverages and tobacco43156.5160.1 Clothing and footwear7083.482.8 Housing, water, electricity, gas and other fuels128154.7155.4 Furniture, household equipment and maintenance59120.9120.5 Health25130.0132.0 Transport149137.6135.0 Communication31112.5113.7 Recreation and culture147102.9101.9 Education26222.2244.3 Restaurants and hotels121132.6135.1 Miscellaneous goods and services91120.3120.5 Overall consumer price index1000 128.3128.2 Weighting the Consumer Price Index in the UK

5. 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

6. The UK Consumer Price Index (CPI) from 2000-2015 Text goes here Inflation is a sustained rise in the general price level e.g. as shown by the annual change in the consumer price index.

7. Inflation Rate in the UK Economy in Recent Years A lower inflation rate means prices rise more slowly – this is known as disinflation

8. 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 Annual rate of change of consumer prices (%)

9. 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 2011 4.52.5-2.53.1 2012 2.81.4-0.62.6 2013 2.61.24.61.5 2014 1.51.18.80.6 2015 (April)0.12.78.60.3 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.

10. 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

11. 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

12. 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 margins Can be caused by: 1.Rising unit labour costs 2.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

13. 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

14. 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 inflationExternal causes of inflation

15. Countries with Highest Inflation in 2015

16. 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

17. 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

18. 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

19. 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

20. Deflation

21. Countries with the lowest inflation rate in 2015 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.

22. 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 fall Real GDP GPL1 AS1 Y1 AD1 AS2 Y2 AD2 GPL2 GPL

23. 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

24. 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

25. 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