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Inflation. Mr E Mc Kee Jan 2002 AS Economics. What is inflation?. Inflation is a sustained rise in the general level of prices It is measured by the retail price index (RPI) Inflation rate is the annual % change in prices The rate of inflation varies over time

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Mr E Mc Kee

Jan 2002

AS Economics

what is inflation
What is inflation?
  • Inflation is a sustained rise in the general level of prices
  • It is measured by the retail price index (RPI)
  • Inflation rate is the annual % change in prices
  • The rate of inflation varies over time
    • 1950s and 1960s – low stable inflation
    • 1970s and 1980s – UK inflation was volatile
    • 1990s – much lower average inflation
    • 2000 – the lowest rate of inflation for over twenty years
how is inflation measured
How is inflation measured?
  • It is measured via the retail price index
  • The RPI is a weighted index which measures the general level of prices
    • Measures the cost of living for a household with average spending patterns
    • Over 600 items in the basket of goods and services
    • Retail prices are measured every month – over 120,000 prices are recorded.
the rpi and the rpix
The RPI and the RPIX
  • The RPI or the headline rate measures the change in price of all 600 goods.
  • The RPIX or the underlying rate is measured in a similar way but excludes mortgage interest payments and is the preferred measure of the government.
what are the costs of inflation
What are the costs of inflation?
  • People on fixed incomes will suffer as prices rise.
  • Saver will suffer as real interest rates will be reduced.
  • UK goods will become more expensive than foreign-made goods therefore the Dx decreases and Dm increases.
  • Inflation leads to uncertainty which reduces investment by firms.
  • Psychological effects – people feel worse off even when they are not.
the causes of inflation
The causes of inflation?
  • Monetarists and Keynesians differ on what causes inflation.
  • Monetarists argue that the sole cause of inflation is an increase in the money supply.
  • They explain their view using the fisher equation of exchange on the quantity theory of money.
the quantity theory of money
The quantity theory of money.
  • MV = PT.
  • Where M = money supply

V = velocity of circulation

P = price level

T = number of transactions.

mv pt
  • Monetarist assume that V and T are fixed and therefore there is a direct relationship between M and P.
  • Monetarists argue that an increase in the money supply will increase AD and this will lead to an increase in prices in the long run.(since the economy is already at full employment)
why does and increase in m lead to an increase in ad
Why does and increase in M lead to an increase in AD
  • Individuals have excess money which they spend on goods and services which increases AD.
  • People use excess money to purchase shares or real assets. This pushes up the price of these assets and therefore people who hold them become more wealthy and are therefore more likely to increases consumption.
  • Keynesian economists believe that inflation has two main causes:
  • Demand pull inflation: too much demand chasing too few goods.
  • Cost push inflation: increases in the cost of production will lead to increased prices.
cost push inflation
Cost push inflation.
  • Increases in production costs will be passed on by firms in order to maintain profit margins.
  • The main causes of cost push inflation are:
    • Increase in unit labour costs – wages
    • Increase in the cost of raw materials
    • Increase in indirect taxes
    • Higher import prices – brought about by a decrease in the ER.
cost push spiral
Cost push spiral
  • Keynesian economists argue that an increase in costs will start of a cost-push spiral.
          • Increased costs

increased wages Increased prices

People worse off

policies to control inflation
Policies to control inflation.
  • Monetarists argue that the control of the money supply is the only effective means of regulating inflation.
  • This is because they believe that “inflation is always and everywhere a monetary phenomenon”. (MV = PT)
  • They argue that inflation can only be controlled by tightening monetary policy.
monetary policy
Monetary policy.
  • Increasing interest rates, decreases the demand for borrowing, and therefore decreases the money supply.
  • Higher interest rates also reduces consumption and investment and therefore reduces AD.
keynesian policies for inflation
Keynesian policies for inflation.
  • Keynesians argue that control of real variables such as AD and AS would be more effective in controlling inflation.
  • They argue that inflation is best controlled through policies such as fiscal policy and incomes policies.
fiscal policy
Fiscal policy.
  • If inflation is demand pull in nature then reducing AD will reduce inflation.
  • Keynesians argue that if the government increase taxes and reduce spending then they will reduce AD an therefore inflation.
fiscal policy for cost push inflation
Fiscal policy for cost-push inflation.
  • If inflation is cost push then the government can decrease inflation by manipulating tax rates.
  • If government decrease excise duty this will automatically reduce the RPIX.
  • It will also help to reduce inflation expectations and therefore wage demands will fall.
exchange rate policy
Exchange rate policy
  • Government could increase the value of sterling by increasing IR or buying sterling.
  • This would increase the price of UK exports and therefore decrease AD.
  • It would also encourage firms to keep costs down.
  • It would also reduce import prices which would reduce cost push inflation.
prices and incomes policies
Prices and incomes policies.
  • The government could introduce a policy which limits the growth of prices or incomes. E.g. 2% per year
  • However the effectiveness of these policies is limited by catch-up effects.
  • Once policies are removed workers will attempt to regain lost wages with excessive pay claims.
current government policy for inflation
Current government policy for inflation.
  • The main instrument used to control inflation in the UK is monetary policy.
  • The Bank of England has a 2.5% target for the RPIX and sets interest rates to achieve this target.
  • Inflation has been below this target for 2 years.
explaining low inflation in the uk economy
Explaining low inflation in the UK economy
  • Several factors explain the absence of inflation
    • Subdued growth of wages and earnings (below 5%)
    • Absence of major inflationary shocks such as sharp jump in international commodity prices
    • Success of the Bank of England 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
    • Success of supply side policies at increasing AS