Inflation
Introduction to Inflation
Inflation is a sustained increase in the cost of living or the general
price level leading to a fall in the purchasing power of money
• The rate of inflation is measured by the annual
percentage change in consumer prices
• The UK government has set an inflation target of 2%
using the consumer prices index (CPI)
• It is the job of the Bank of England (BoE) to set
monetary policy interest rates so that inflationary
pressures are controlled and the inflation target is
reached
• A fall in inflation is not the same as a fall in prices! Only
when there is deflation will the general price level fall
Inflation – Some Key Terms
Consumer Price Index
(CPI)
A measure of the price level in the economy based on the
prices of a collection of products designed to reflect the
consumption basket of the average consumer
Deflation
A decline in the general price level in an economy, signified by
an annual inflation rate below 0% (negative).
Disinflation
Disinflation is a fall in the rate of inflation e.g. from 5% to 2%.
Prices are still rising but at a slower rate.
Hyper-inflation
A period of very high rates of inflation, usually leading to a loss
of confidence in an economy’s currency.
Inflation rate
The annual rate of change of the average price of goods and
services.
Unit labour costs
Reflect total labour costs, including social security and
employers’ pension contributions, and including the costs of
self-employed labour, incurred in the production of a unit of
economic output.
Weighting the Consumer Price Index in the UK
Weights
CPI in June
2014
CPI in June 2015
Food and non-alcoholic beverages
110
143.2
140.1
Alcoholic beverages and tobacco
43
156.5
160.1
Clothing and footwear
70
83.4
82.8
Housing, water, electricity, gas and other fuels
128
154.7
155.4
Furniture, household equipment and maintenance
59
120.9
120.5
Health
25
130.0
132.0
Transport
149
137.6
135.0
Communication
31
112.5
113.7
Recreation and culture
147
102.9
101.9
Education
26
222.2
244.3
Restaurants and hotels
121
132.6
135.1
Miscellaneous goods and services
91
120.3
120.5
1000
128.3
128.2
Category in the CPI
Overall consumer price index
Limitations of the CPI as a measure of inflation
Few households are average – the published figure for inflation is
rarely the actual rate of inflation experienced by different people
1. The CPI is not fully representative - it will be inaccurate for the
‘non-typical’ household, e.g. 14% of the CPI index is devoted to
motoring costs - inapplicable for non-car owners.
2. Spending patterns: e.g. Single people have different spending
patterns from households that have one or more children
3. Changing quality of goods and services: Although the price of a
good or service may rise, this may also be accompanied by
improvements in quality / performance of the product
4. New products: The CPI is slow to respond to new products and
services – the CPI basket is changed each year but only a few
items fall out / come in
The UK Consumer Price Index (CPI) from 2000-2015
Consumer Price Index (2005=100)
140
130
126.1
128
128
123
119.6
120
114.5
108.5
110
100
95.4 96.7
94.2
93.1
98
100
102.3
110.8
104.7
90
80
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Text goes
Inflation
is ahere
sustained rise in the general price level e.g. as shown by the
annual change in the consumer price index.
Inflation Rate in the UK Economy in Recent Years
5.0%
4.5%
A lower inflation rate means
prices rise more slowly – this is
known as disinflation
4.5%
4.0%
3.6%
Inflation rate
3.5%
3.3%
3.0%
2.8%
2.5%
CPI inflation target = 2%
2.1%
2.3% 2.3%
2.6%
2.2%
2.0%
1.4% 1.3%
1.3%
1.2%
1.5%
1.0%
1.5%
0.8%
0.5%
0.0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
CPI Inflation in the UK over the last 20 Years
Annual rate of change of consumer prices (%)
7
6
5
4
3
2
1
0
-1
-2
CPI all items
CPI goods
CPI services
-3
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN JAN
The inflation rate for goods such as clothing and computing equipment has been,
on average, lower than for service such as insurance and education
UK Inflation Rates in Recent Years
UK Consumer
Price Inflation
UK Whole
Economy
Average
Earnings
Halifax House
Price Inflation
Inflation in the
European
Union
Per cent
Per cent
Per cent
Per cent
2011
4.5
2.5
-2.5
3.1
2012
2.8
1.4
-0.6
2.6
2013
2.6
1.2
4.6
1.5
2014
1.5
1.1
8.8
0.6
2015 (April)
0.1
2.7
8.6
0.3
Year
The Bank of England’s target is for inflation to be 2%. The Governor of the Bank of England
must write an open letter to the Chancellor if inflation is more than one percentage point
higher or lower than this target (i.e. more than 3% or less 1%). CPI Inflation has been either
above 3% or less than 1% in 25 of 57 months since May 2010.
Source: HM-Treasury Databank
What are the Main Causes of Inflation?
Demand Pull inflation
Inflation Expectations
• Caused by excess aggregate demand
• Often linked to a money and credit boom
• Economy close to full capacity (inelastic AS)
• Positive output gap (AD > potential GDP)
Once inflation becomes
established in an economy it
can be difficult to remove.
Cost Push Inflation
• Rising wage costs in labour market
• Increasing raw material and component
costs from domestic and overseas suppliers
• Rising import prices due to a falling
exchange rate – this increases import costs
Administered Prices
• Changes in regulated prices e.g. water bills
• Changes in indirect taxes and subsidies
• Changes in environmental taxes
Most agents in the economy
(e.g. workers, businesses and
lenders) will raise their
inflation expectations and
build it into their calculations
and decisions
A rise in inflation can lead to
an increase in inflation
expectations. This can then
feed through to higher wage
claims and rising costs
Some factors affecting inflationary pressures
Rising property
prices
Increased
consumer wealth
Demand pull
inflation risk
Increasing
world oil prices
Higher costs
for businesses
Cost-push
inflation risk
Depreciating
exchange rate
Increased import
prices + rising
exports
Cost-push and
Demand pull
inflation risk
Rapid expansion
of money and
credit from banks
Rising consumer
spending financed
by loans
Demand pull
inflation risk
Cost-Push Inflation using AD-AS Diagram
Cost-push inflation occurs
when firms respond to rising
costs by increasing their prices
to protect profit margins
Can be caused by:
1. Rising unit labour costs
2. Higher prices for
important
components/raw materials
3. A depreciation in the
exchange rate causing a
rise in import costs
4. An increase in business
taxes e.g. VAT or
environmental taxes such
as a carbon tax
GPL
AS2
AS1
GPL2
GPL1
AD
Y2 Y1 Real GDP
Demand Pull Inflation using AD-AS Diagram
GPL
AD1
AD2
AS
GPL2
GPL1
Y1
Y2 Real GDP
1. Demand-pull inflation
occurs when AD grows at
an unsustainable rate
leading a positive output
gap (i.e. Actual GDP >
Potential GDP)
2. When there is excess
demand, producers can
raise their prices and
thereby achieve bigger
profit margins
3. Demand-pull inflation is
most likely when there is
full employment of
resources, when aggregate
supply is inelastic
Analysis: Internal and External Causes of Inflation
Internal causes of inflation
External causes of inflation
A large surge in
property prices
Higher wages /
labour costs
Increase in world
oil / gas prices
Inflation in global
commodity prices
Boom in credit /
money supply
Rise in business
taxes e.g. VAT
Depreciation of
the exchange rate
High inflation in
other countries
Countries with Highest Inflation in 2015
Inflation rate (per cent) compared to previous year (March 2015)
0.0%
20.0%
40.0%
60.0%
80.0%
100.0%
120.0%
Venezuela
96.8%
Ukraine
33.48%
South Sudan
Belarus
28.98%
22.08%
Sudan
19.03%
Argentina
18.65%
Russia
17.94%
Malawi
17.31%
Islamic Republic of Iran
16.5%
Sierra Leone
13.07%
Tajikistan
12.85%
Eritrea
12.26%
Ghana
12.2%
Kyrgyz Republic
10.75%
Egypt
10.26%
Why is High Inflation an Economic Problem?
Many governments target a low but positive rate of inflation. They
believe persistently high inflation can have damaging consequences
• Inequality: Inflation has a regressive effect on lower-income families in
developed & developing countries – most of their wealth is held in cash
• Falling real incomes – if wage rises lag behind price increases each year
• Negative real interest rates: If the interest on savings is lower than inflation
• Cost of borrowing: High inflation may also lead to higher interest rates for
businesses and consumers with debts (e.g. Rising mortgage rates)
• Risks of wage inflation: This leads to rising labour costs and lower profits
• Business competitiveness: A high relative rate of inflation can reduce
competitiveness which will lower demand for the country’s exports
• Business uncertainty: High and volatile inflation is not good for confidence
partly because businesses cannot be sure of what their costs and prices are
likely to be. This uncertainty might lead to a fall in capital investment
Possible Winners and Losers from High Inflation
One of the effects of inflation is that it can lead to arbitrary changes
in the distribution of real incomes and wealth in a country
Winners
Losers
• Workers with strong wage
bargaining power
• Debtors if real interest
rates are negative
• Producers if prices rise
faster than costs
• Retired on fixed incomes
• Lenders if real interest
rates are negative
• Savers if real returns are
negative
• Workers in low paid jobs
Why is inflation difficult to forecast accurately?
Forecast inflation for UK (source: BoE)
Volatile
global
energy
prices
Government
indirect
taxes can
change
Volatile
food prices
Changes in
value of
the
currency
Uncertain
growth of
aggregate
demand
The chart shows the UK CPI inflation
forecast published by the Bank of
England. The probability fan chart for
inflation indicates the range of
probabilities for inflation in the
forecast period.
Macroeconomic Policies to Control Inflation
Inflation can be reduced by policies that (i) slow down the growth
of AD or (ii) boost the rate of growth of aggregate supply (AS)
• Fiscal policy: A tightening fiscal policy would include less spending on
public and merit goods or welfare payments or raising direct taxes
• Monetary policy:
• A ‘tightening of monetary policy’ via higher interest rates or a
reversal of quantitative easing or tougher controls on bank lending
• Higher interest rates may cause the exchange rate to appreciate
bringing cheaper imported goods and services
• Supply side policies to increase productivity, competition and
innovation
• Direct controls
• Public sector pay controls e.g. Limiting pay rises for NHS workers
• Capping or other regulation of prices of utilities such as water bills
Deflation
Countries with the lowest inflation rate in 2015
-1.8%
Grenada
Switzerland
Zimbabwe
Bulgaria
Micronesia
Cyprus
Croatia
Poland
El Salvador
Dominica
Spain
Marshall Islands
Slovenia
Lithuania
Camboadia
-1.6%
Inflation rate compared to previous year
-1.4% -1.2% -1.0% -0.8% -0.6% -0.4%
-0.2%
0.0%
-1.55%
-1.19%
-1.05%
-1.03%
-1%
-1%
-0.89%
-0.83%
-0.8%
-0.77%
-0.73%
-0.59%
-0.39%
-0.31%
-0.31%
Deflation is a persistent fall in a country’s general price level. A number of
countries were experiencing negative inflation rates in May 2015 among
them a growing cluster of countries inside the European Union.
The Causes of Price Deflation
Deflation is a persistent fall in the general price level of goods and
services. The rate of inflation becomes negative.
GPL
Demand-side causes of deflation
AS1
AS2
GPL1
GPL2
AD1
AD2
Y2 Y1
Real GDP
• Deep fall in AD causing a
persistent recession /
depression
• Large negative output gap – i.e.
high level of spare capacity
Supply-side causes of deflation
•
•
•
•
Improved productivity
Technological advances
Significant fall in wage rates
High exchange rate causing
import prices to fall
Evaluating the Consequences of Price Deflation
1. Holding back on spending: Consumers may postpone demand if they
expect prices to fall in the future
2. Debts increase: The real value of debt rises with deflation and higher
real debts can be a big drag on consumer confidence
3. The real cost of borrowing increases: Real interest rates will rise if
nominal rates of interest do not fall in line with prices.
4. Lower profit margins: Lower prices can mean reduced revenues &
profits for businesses - this can then lead to higher unemployment as
firms seek to reduce costs by shedding labour.
5. Confidence and saving: Falling asset prices such as price deflation in
the housing market hits personal sector wealth and confidence
6. Income distribution: Deflation leads to a redistribution of income
from debtors to creditors – but debtors may default on loans
7. Deflation can make exporters more competitive eventually – but this
often comes at a cost i.e. higher unemployment in short term
Evaluating the Consequences of Price Deflation
Real interest
rates rise
Real level of
debt rises
Pressure for
lower wages
Declining
business profits
Rise in cyclical
unemployment
Improved price
competitiveness
Economic Policies to Avoid Price Deflation
The main approach to avoiding deflation is to use macro-stimulus
policies either by loosening monetary policy and/or fiscal policy
Low interest rates and quantitative easing
•
•
•
•
In some countries, policy interest rates have become negative e.g. Switzerland
Cheaper loans for businesses and households
Expanding the supply of credit in banking system
QE used by many central banks including BoE and European Bank
Fiscal stimulus measures
• Higher government spending (e.g. capital projects)
• A rise in government borrowing to inject demand into the circular flow
• Lower direct taxes to increase disposable income and spending
Other measures to stimulate aggregate demand
• Attempts to lower the value of the exchange rate (perhaps via central bank
intervention to sell their currency in the market)
• Higher taxes on savings to encourage consumption