IB Economics—internal assessment coversheet

School code Name of school

Li Po Chun
United World
College

Matias Fonolla
Candidate name

Candidate number

Esther Chau
Teacher

State pension up £5 after inflation surge

Title of the article

The Express (London, England)

Source of the article

October 18, 2017

Date the article was published

April 20, 2018

Date the commentary was written

Word count (750 words maximum)

Section 1: Microeconomics

Section of the syllabus the article Section 2: Macroeconomics

relates to (please tick the one that
is most relevant)
Section 3: International economics

Section 4: Development economics

PENSIONERS will get almost £5 a week extra thanks to a surge in inflation. The cost of living jumped to a five-
year high in September as prices went up by three per cent - up from 2.9 per cent in August. The rise was fueled
by higher food and transport costs, according to the Consumer Price Index. But the state pension will go up by
£4.78 a week because of the "triple lock" protection policy, under which it rises in line with inflation or wages if
either of those is higher than 2.5 per cent. But homeowners could now face higher mortgage repayments as the
Bank of England could push up the base interest rate from its record low of 0.25 per cent in a bid to bring
down inflation. The change in inflation for September is important as a number of state benefits are increased
annually in line with this data. Public sector pensions will also be increased from April 2018 using
September's inflation figure. Andrew Tully, pensions technical director at Retirement Advantage, said: "The news
really is a double-edged sword. Incentive "On the one hand key state benefits including the pension will increase,
meaning millions of pensioners will benefit from April. Public sector pensions in payment are also linked to
September's inflation data and will also increase. "People saving hard for retirement also have an opportunity to
save a little more as the lifetime allowance - the overall limit on the value of your pensions before you get hit by
an extra tax charge - will also increase by £30,000. "This doesn't sound like a big incentive, but anything that
helps people who are doing the right thing but are being hit by this arbitrary limit is welcome. "The sting in the tail,
though, for anyone trying to make ends meet is the seemingly never-ending rise in the cost of living. Households
need to find an extra £825 a year to maintain their standard of living. And with wages lagging behind, living
standards will continue to be affected." As the inflation figures were published by the Office for National Statistics
yesterday, Bank of England governor Mark Carney told MPs that rate-setters on the Bank's Monetary Policy
Committee believed a rise in interest rates may be needed over the coming months as it looks to tackle
surging inflation caused by the weak pound.

Commentary

Inflation is a constant rice in prices over a certain period of time. The problem here is that wages don’t go up at
the same rate as prices and people’s real wealth is reduced. In the long-term this can negatively affect living
standards. The government wants to protect groups that are vulnerable to inflation, through an increase in
transfer payments. This is a payment made or income received in which no goods or services are being paid for,
such as a benefit payment or subsidies given by the government. For example, pensions. By increasing
pensions, pensioners will see an increase in their real wealth, enabling them to maintain their consumption of
basic goods and services, and thus, living standard, despite inflation. This attempt to salvage pensioners’ real
wage is combined with a contractionary monetary policy aimed to reduce inflation by which the Bank of England
will increase interest rates. Interest rate is the amount charged, expressed as a percentage of principal, by a
lender to a borrower for the use of assets.

In the graph above, we firstly (1) see cost-push inflation shifting AS to AS1. A possible cause for the increased
inflation suggested in the article is the weak pound. In theory, devaluation of the pound will increase the price of
imports. A big majority of British firms utilize imported oil in their production process. The weaker pound
increased the price of oil and consequentially firms’ cost of production, shifting AS to the left. This increases price
(P1 to P2) and decreases output (R1 to R2). The increase in pensions (2) regarding inflation shifted AD to AD1
since pensioners now have more disposable income used for consumption (increase in C). This shift further
increases price level (P2 to P3) and RGDP (R2 to R3).
To counter inflation the BoE is planning on increasing interest rates (3). If this is effective AD1 would shift to AD3
as higher interest rates discourage consumption and investment, since the opportunity cost of borrowing is higher
and saving seems more attractive to consumers. This results in a decrease both in price level (P3 to P4) and in
RGDP (R3 to R4).

Altogether, we have two combined policies in this case. First an increase in transfer payments that aims to
protect pensioners’ real wealth but also increases prices and a contractionary monetary policy that increases
interest rates to fight back inflation, the root of the problem. In theory, the leftwards contractionary policy shift will
be more impactful than the rightwards pensions shift regarding AD since only the consumption of a small
demographic dependent of pensions is increased whereas the increase in interest rates will affect the behavior of
all consumers conforming C and all firms (I).

In order for this contractionary monetary policy to be effective, marginal efficiency of investment (MEI) has to be
elastic. This means that a change in interest rates will produce a meaningful impact in firms’ behavior. In this
graph we see that the more elastic MEI2 showed a more substantial decrease in investment (I3 to I4) than ME1
(I1 to I2) if interest rate was raised from 0.25% to 0.35%.

Implementation of this policy is based on the assumption that UK firms’ MEI is elastic. However, an increasing
inflation rate may negatively affect business confidence, making firms reluctant to borrow money at any given
rate, making MEI inelastic and the policy ineffective.

Even more so, the implementation of this policy can have undesirable effects in the long term. An overshooting in
the increased interest rate may constrict the economy too much as investment and consumption would plummet,
eventually leading to a fall in production due to lack of demand, pushing the economy into recession. This has
happened in the past. To fight US inflation in the 70’s, the Federal reserve increased interest rates, keeping the
country from falling into an inflationary spiral in the short term, but generating a recession in the long term.

In conclusion, I believe that although there are possible setbacks, this policy will succeed in updating pensioners’
real wealth to inflation. This increase in transfer payments will protect said vulnerable groups until the
contractionary policy sets inflation rates back to government’s standards. I believe this last policy will be effective
as the UK is currently in a slight inflationary gap regarding the business cycle, an ideal situation for these kinds of
procedures. But it will be the BoE’s responsibility to set an interest rate that is effective and stabilizing both in the
short and long term.