AS inflation

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AS inflation Powered By Docstoc
      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
  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
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
        Retail prices are measured every month – over
         120,000 prices are recorded.
The RPI and the RPIX
  The RPI or the headline rate
   measures the change in price of all 600
  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.
UK inflation performance
                 RPIX INFLATION SINCE 1988
  Annual percentage change

                                  88   89   90   91   92      93     94    95     96       97   98   99   00   01

                                                           RPIX inflation - monthly data
Inflation and deflation
                             INFLATION AND DEFLATION IN THE UK
                                                        All Items in RPI
  Source: Retail Price Index (December 2000)

                                                  Consumer Durables
                                                       Seasonal Foods
                                                        Canteen Meals
                                                        Water Charges
                                                       Housing Repairs
                                                 Electrical Appliances
                                                  Clothing & Footwear
                                                          Petrol and Oil
                                                          New Vehicles
                                               Audio-visual Equipment

                                                                            -20   -15       -10        -5         0         5    10
                                                                                    % change in prices over previous 12 months
What are the costs of
    People on fixed incomes will suffer as prices
    Saver will suffer as real interest rates will be
    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?
  Monetarists and Keynesians differ on
   what causes inflation.
  Monetarists argue that the sole cause of
   inflation is an increase in the money
  They explain their view using the fisher
   equation of exchange on 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.
  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
 1.   Individuals have excess money which they
      spend on goods and services which
      increases AD.
 2.   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
     Keynesian economists believe that
      inflation has two main causes:
 1.   Demand pull inflation: too much
      demand chasing too few goods.
 2.   Cost push inflation: increases in the
      cost of production will lead to
      increased prices.
Demand pull inflation
Cost push inflation.
          Increases in production costs will be passed
           on by firms in order to maintain profit
          The main causes of cost push inflation are:
     i.      Increase in unit labour costs – wages
     ii.     Increase in the cost of raw materials
     iii.    Increase in indirect taxes
     iv.     Higher import prices – brought about by a
             decrease in the ER.
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.
   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.
  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
  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.
   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
  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
  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
  It would also reduce import prices which
   would reduce cost push inflation.
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
  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.
UK inflation performance
   Percentage increase in price on a year earlier




   1                                                              RPIX
         96                     97                   98                    99                   00   01
                             RPIX = Retail prices index, excluding mortgage interest payments
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
        Strong pound has helped to keep inflation under
        Expansion of information technology has helped to

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