INFLATION

“Inflation is a sustained increase in the general level of

prices over time. Inflation refers to small and gradual rises
in prices over time while hyperinflation describes a situation
of large and accelerating price rises.”

• The rate of inflation is the percentage increase in prices

over a period of time, usually annually.
• The gov‟ts preferred measure of inflation is the
Consumer Price Index (CPI).
• It measures the level of prices for a wide range of goods
and services bought by consumers in the country at a
point in time
 Retail Price Index (RPI) includes mortgage interest
payments giving the underlying or „core‟ measure of
inflation also known as GDP deflator and is the most
comprehensive measure of the rate of inflation that covers
all goods and services produced in the economy.

Inflation = Price index in period – Price index in previous period x 100

Price index in the previous period
UK Inflation
 Indices contain a number of items of bias:

• Errors in data collection and estimation.

• Introduction of new goods or services.
• Quality improvements over time.
• Changes in the typical basket of goods
and services purchased
 Causes of inflation
“ Demand – pull inflation is the term used to
summarise the various factors leading to
inflation that originates in the demand side of the
economy or changes in aggregate demand.”
• Increases in aggregate demand due to changes
in consumption, investment, gov‟t spending or
net exports.
• Could be caused by an expansion in money
supply and lower interest rates.
• May result in changes in fiscal policy or
monetary policy.
 Causes of inflation
“Cost – push inflation is a term used to describe
cost pressures due to supply side factors that
cause changes in aggregate supply”
• Two main sources: excessive wage demands or
increase in price of imported raw materials and
fuels.
• Supply side changes may originate from the
domestic economy i.e. higher wages or higher
prices from the international economy.
 Expectation-induced effect
• Prices or costs of production are expected to
rise they may trigger demand and supply side
responses in advance and thus cause inflation.
• Expectation induced inflation caused by workers
who expect prices to rise and therefore demand
higher wages in advance of the actual inflation,
similarly if firms expect inflation they may build
this into their prices
• May well be rapid inflation.
 Consequences
• Fully anticipated inflation has no significant effect on the
overall wealth of the economy on the distribution of
income. Banks may adjust for inflation by altering
nominal rates on savings. Gov‟ts may adjust the
thresholds to ensure there is no fiscal drag resulting in
inflation, they may also increase transfer payments such
as pensions and benefits to ensure recipients have the
same level of income.
• Unanticipated inflation affects the real level of wages,
interest rates, taxes and transfer payments. Real wages
may be affected even when inflation is anticipated simply
because workers and the unions are unable given the
state of the labour market to enforce nominal wage
increases to fully compensate.
 Inflation and international
competitiveness
• Likely to be a cost in terms of international competitiveness
especially when operating a fixed exchange rate policy. If the rate
is greater than that of its competitors it is likely to suffer deterioration
in price competitiveness of its exports and domestic will become
less price competitive compared to imports and deterioration in the
balance of payments.
• If floating exchange rates, currency likely to experience
depreciation in its exchange rate reducing the costs of inflation.
However currency devaluation could cause further inflation due to
the rising import costs.
• Could lead to an „Inflationary Spiral‟
• Inflation with floating exchange rates, leading to currency
speculation foreign exchange market leading to considerable
instability in the international value of currency and damage to
international trade and capital flows.
 Relationship between inflation
and unemployment
• As the economy reaches full employment output the
greater inflationary pressure. Lack of spare capacity and
bottlenecks in the availability of factors of production,
notably labour.
• Conversely in high unemployment inflationary pressures
will be subdued as a result of slack in the labour market
and reduced wage pressures.
• The trade off or inverse relationship between the level of
unemployment and the rate of money wage inflation.
This is at the heart of the argument between Keynesian
and Monetarists for many years, critical to gov‟ts as they
seek to control inflation and achieve sustainable long
term economic growth.
 Phillips Curve
In 1958 A.W.Phillips used UK data for 1861-1957
to show a strong negative relationship between
rate of change of money wages and the level of
employment. Statistics showed a stable level for
almost 100 years with higher unemployment
associated with lower rates of growth of wages.
(Also later argued that there is also a negative
relationship between the rate of change of prices
(inflation) and the level of unemployment.
“The Phillips curve shows the statistical relationship
between inflation and unemployment over time.”
 Phillips Curve
This suggested the gov‟ts could trade off a
level of unemployment for a rate of
inflation. Gov‟ts could move the economy
up and down the curve but could not
reduce unemployment below point A
without triggering inflation. This rate is
associated with equilibrium in the labour
market where the demand for labour at a
given real wage rate is equal to the supply
of labour.
 In real life…………….

• The 1960s saw gov‟ts actively attempted to manage their

economies on the basis of the Phillips curve.
• Provided an attractive choice that could be triggered at
the appropriate times.
• By the end of the 60s the relationship began to look
unstable as unemployment, wages and prices all began
to rise together.
• During the 70s and early 80s a marked outward shift in
the relationship with „stagflation‟ being prominent in a
number of industrial economies.
• Keynesian techniques proved to be inflationary.
 Policy implications of inflation
• Monetary policy saw the long term Phillips
curve as a vertical at the natural rate of
unemployment and appropriate policy to bring
down inflation must be to keep tight control of
the money supply.
( Dominant with the Thatcher and Regan gov‟ts)
• Fiscal policy uses reductions in spending
and/or an increase in taxation to directly reduce
aggregate demand. The preferred policy of
Keynesian economists, this policy is however
likely to lead to high transitional unemployment
and perhaps recession.
 Price and Incomes Policy
• Monetary and fiscal policies attempt to control inflation by restricting
growth in aggregate demand, prices and incomes policy.
• Setting up of price and incomes controls.
• Force firms to avoid unjustified price rises and wage demands.
• Voluntary agreements from employers and employees to keep
price rises incomes within limits.
• Passing legislation to regulate or freeze prices and wages.

Prices and incomes policies break down over the longer term as
they do not address demand pressures and gov‟ts acting contrary to
the market economy and can lead to price and wage distortions
resulting in growing misallocation of resources.
Deflation

Benign deflation relates to increased aggregate supply and production

efficiency allowing unit costs of production and prices to fall.

Malign deflation refers to a lack of aggregate demand referred to as a

„deflationary gap‟ with profound implications for economic activity, economic
policy, business planning and wage bargaining.

In terms of deflation real value of money balances rise as prices fall. This
could cause economic recession as in Japan in the 1990s.

Policies to deal with malign inflation concentrate on expanding aggregate

demand, cuts in interest rate may be insufficient to stimulate demand.
Impotency in monetary policy in a time of malign deflation are likened to
„pushing on string‟ as against policies in times of inflation as „pulling in
string‟.