what is inflation?

Inflation measures the annual rate of change of the general price level in the economy.
Inflation is a sustained increase in the average price level. We focus here on the overall level
of prices throughout the economy rather than prices in one particular market or industry. It is
quite possible for prices to be falling, for example in audio-visual equipment or textiles, but
for there to be general price inflation across a wide range of goods and services.

Inflation and the Price Level

When prices rise, the value of money falls. There is an inverse relationship between the
price level and the internal purchasing power of money. When there is inflation money buys
less in real terms. People can protect themselves against the effects of inflation by investing in
financial assets that give a rate of return at least equal to the rate of inflation.

Inflation & Phillip Curves, outcome two.

Hyperinflation is extremely rare, although some countries experience something approaching
it. Recent examples include Argentina, Brazil, Georgia and Turkey (where inflation reached 70%
in 1999). The classic example of hyperinflation was of course the rampant inflation in Weimar
Germany between 1921 and 1923.

When hyperinflation occurs, the value of money becomes worthless and people lose all
confidence in money both as a store of value and also as a medium of exchange. Often drastic
action is required to stabilize an economy suffering from high and volatile inflation - and this
leads to political and social instability. The International Monetary Fund is often brought into
the process of implementing economic reforms to reduce inflation and achieve greater
financial stability

The economy is continuously experiencing changes in relative prices as demand supply

conditions alter in individual markets. For example the relative price of hi-tech goods including
PCs and Multi-Media equipment is falling whilst the relative price of cigarettes and fuels has
increased in recent years not least because of rising levels of indirect taxes applied on these
goods by the government in successive budget announcements.

There are 2 main reasons why prices could increase in our economy

1. COST PUSH

An increase in costs may lead to an increase in prices.

Examples:
Raw material prices ( possibly from abroad) increase...
...Costs to business increase...
...Business still wants to make a profit...
...Business puts its prices up...
...Consumers can buy less with their money...
...Workers demand and receive pay increases...
...Businesses costs increase again...
...Businesses put prices up again

On and on and on

Inflation & Phillip Curves, outcome two.

2. DEMAND PULL

If there is too much demand for goods and services in the economy then prices may be forced
upwards.

Individuals and businesses experience a feelgood factor ( maybe they have just had a tax cut)

They wish to buy more goods and services

Only so many goods and services are available at present

Suppliers experience so much demand for their limited number of goods that they decide to
put up prices

ACTION

a. In the cost push example, why are workers demanding higher wages?
b. How does a ticket tout use demand pull to increase their ticket prices?
c. How could a demand and supply diagram show demand pull inflation?

How to reduce the level of inflation in an economy

1. REDUCE DEMAND PRESSURES

If inflation is caused by high demand then

* Raise interest rates to reduce consumers disposable incomes

* Raise interest rates to discourage borrowing and demand
* Raise taxes to reduce disposable income and spending
* These policies should all reduce peoples ability to spend too much money

2 REDUCE COST PUSH PRESSURES

If inflation is caused by high costs

• Limit wage increases if possible e.g. public sector workers

• Force electricity and gas companies to hold their prices
• Increase the value of £ in order to reduce the cost of importing

3. REDUCE MONEY SUPPLY PRESSURES

If inflation is caused by too much money in the economy

• Print less money

• Withdraw some money from circulation.

Each of the above approaches has its advantages and disadvantages.

POLICY 1 is effective but will be unpopular with consumers and may cause a minor recession

Inflation & Phillip Curves, outcome two.

POLICY 2 could be effective but it is very difficult for the government to tell private firms how
much to charge for inputs and also how much to pay their workers

ACTION

A Why will a rise in interest rates reduce demand in the economy?

deflation

Deflation refers to a decrease in the general price level of the economy. A fall in prices in
particular markets, such as housing, share prices or the market for electronic goods or textiles
is not the same as economy-wide deflation.

Most economists believe that disinflation or falling inflation is beneficial for the economy. A
stable price level can lead to better decisions and a more efficient use of scarce resources.
Lower inflation also helps to stabilize inflationary expectations. A decline in prices after an
improvement in productivity is allows companies to cut costs and prices, thereby raising living
standards.

The type of deflation that analysts fear is the kind that is broadly-based throughout the
economy, long-lasting, and symptomatic of a weak economy stuck in recession. When prices
are falling , consumers may decide to postpone purchases in the expectation of buying the item
at a cheaper price later on. This causes a fall in demand and can create further price declines.

Deflation also causes real interest rates to rise, curbing demand. As well, falling asset prices
(including housing and equities) reduce personal sector wealth and inflate the real value of
debt, resulting in higher business failures and personal bankruptcies. It is clear therefore
that deflation in the economy brings risks as well as opportunities. This is something that a
government and the monetary authorities (i.e. the Central Bank) might be concerned to avoid.

DEFLATION AND ECONOMIC POLICY

Deflation can normally be controlled by an expansionary monetary policy with the Central
Bank or the Government allowing the money supply to expand. This causes interest rates to fall

Inflation & Phillip Curves, outcome two.

and stimulates consumer spending and investment demand. Occasionally though, when prices
are falling, lenders may call in loans or refuse to lend out to potential borrowers. This is known
as a credit crunch.

Cutting interest rates may not be sufficient during a credit crunch. In this case, expansionary
fiscal policy (lower direct and indirect taxes and higher government spending) is often
prescribed to cure deflation.

One reason deflation is difficult to cure is that nominal interest rates cannot fall below zero,
while prices of goods and services can fall for a long time. In this event, monetary policy is
unable to prevent higher real interest rates and the economy spirals downwards towards a
slump caused by falling prices, contracting output, falling investment, plant closures and
increasing levels of job losses in those industries affected.

Deflation is occurring in the markets for some goods in the UK economy. The annual rate
of inflation for products such as textiles and audio-visual equipment has been negative
for some time leading to cheaper prices for consumers and an increase in their real
purchasing power. Evidence for this is found in the chart above.

BACKGROUND

The Phillips curve illustrates the relationship between inflation and unemployment in an
economy. The downward sloping nature of the curve shows that there is, in theory, a trade-off
between inflation and unemployment in the short run - this means that in order to lower the
rate of unemployment in an economy, say, we must be prepared to have a higher rate of
inflation.

The economist A.W. Phillips who first put forward the theory in 1958, demonstrated that one
stable curve represented the trade-off between unemployment and inflation, and the previous
96 years of data confirmed this. Soon after Phillips suggested this, the data seemed to prove
him wrong, as this chart shows:

Inflation & Phillip Curves, outcome two.

There seems to have been no fixed relationship between inflation and unemployment as
Phillips had argued

SHIFTING CURVES

Though there was no overall relationship between inflation and unemployment, a closer look at
the data shows that there have been in fact several distinct curves over the past thirty years.
By stripping away some of the more volatile data we can see that the trade-off shifted
outwards between the early-70s to the early-80s:

Inflation & Phillip Curves, outcome two.

There are a number of causes for this shift in the Phillips curve, including:

Oil price shocks caused when the Oil Producing and Exporting Countries (OPEC) decided to
raise the price of oil dramatically

Expansionary fiscal policy by the Chancellor of the Exchequer Anthony Barber, which caused
the economy to overheat (the so-called 'Barber Boom')

High interest rates which reached 17% in 1980, which contributed to a severe recession in the
UK manufacturing sector, with the loss of 23% of manufacturing jobs.

SHIFTING IN AGAIN.

In more recent times, however, we seem to have seen the Phillips curve shift inwards:

The possible causes for this include:

A more flexible labour market through policies such as the New Deal gateway, the restriction
of Trades Unions powers, which aim to increase the incentives to work, reduce labour market
rigidities and raise participation rates.

The use of Inflation targets in monetary policy, with an independent Bank of England helping
to deliver consistently low inflation rates.

Inflation & Phillip Curves, outcome two.

CONCLUSION

This brief look at the trade-off between unemployment and inflation shows that there has not
been one steady curve showing the relationship over the past thirty years. If we look individual
periods, however, there does appear to be a number of curves showing the trade-off over that
period.

What is also interesting to note is the change in the gradient of the curve in recent times: what
seems to be the case is that inflation is far less volatile now than it used to be, so that for a
given fall in unemployment, for example, the increase in the inflation rate is much smaller
than it would have been in the 1980s.

This could suggest that the Government (and more specifically the Bank of England) could
allow the country to grow at a faster rate without running the risk of breaking its inflation
target of 2½% per year - that is to say, the trend growth rate of the economy may have risen.

Inflation & Phillip Curves, outcome two.