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Inflation is a sustained increase in the general
level of prices Inflation rate is the annual %
change in prices
A fall in inflation means that prices are rising
but at a slower rate than before.
When prices rise, the real purchasing power
of cash declines
Deflation on the other hand is a sustained
decrease in general prices
ANNUAL PERCENTAGE CHANGE IN RPI COMPONENTS
-5.3
Source: ONS CPI Data March 2002
Leisure Goods
-1.9
-1.4
Motoring Expenditure
-1.3
1.2
Alcoholic Drink
2.2
2.5
Personal Goods & Services
2.5
3.3
Food
3.6
3.7
Household Services
4.1
4.1
Leisure Services
6.7
-6
-4
-2
0
2
% Change over 12 Months
4
6
8
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Inflation has two main causes
Demand – pull inflation
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When aggregate demand is rising faster than the ability of the economy
to supply goods and services – leading to excess demand
Positive output gap (when actual GDP > Trend GDP)
Businesses respond by raising prices to increase their profit margins
Demand-pull inflation associated with the boom phase of the economic
cycle
Cost – push inflation
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Occurs when costs of production are increasing
This leads to inward shift in short run aggregate supply
Firms raise prices to protect their profits
Wages often follow prices – if there is an increase in inflation, this may
lead to a rise in pay claims – this is known as a wage price spiral
Price Level
SRAS1
P1
AD1
Y1
Real National Output
Price Level
SRAS1
P1
AD2
AD1
Y1
Real National Output
Price Level
SRAS1
P2
P1
AD2
AD1
Y1
Y2
Real National Output
Price Level
SRAS1
A higher level of
aggregate demand (e.g.
caused by rising consumer
spending) puts upward
pressure on the price level
P2
P1
AD2
AD1
Y1
Y2
Real National Output
Price Level
SRAS1
P1
AD1
Y1
Real National Output
SRAS2
Price Level
SRAS1
P1
AD1
Y1
Real National Output
SRAS2
Price Level
SRAS1
P2
P1
AD1
Y2
Y1
Real National Output
SRAS2
Price Level
SRAS1
Shifts in AS are caused by
changes in input costs –
P2
for example a rise in oil
prices leads to higher
costs and an inward shift
of SRAS – and a higher
general price level
P1
AD1
Y2
Y1
Real National Output
Basic
Pay
Exchange rate /
Profit margins
Import
Prices
Bonuses +
overtime
Global
Economic
Cycle
+
Earnings
Productivity
Unit
labour
costs
+
Commodity
Prices
+
Economic
Cycle
(e.g. ICT
impact)
inflation
Taxes
+
Secular
Influences
=
Fiscal Policy
Profit
Margins
Economic
Cycle
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Economic costs of inflation depend on
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The degree of inflation – more costly when inflation is high
Whether inflation is
 Correctly anticipated by consumers and producers
 Unanticipated – I.e people’s expectations of inflation turn out to be wrong
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Whether inflation in one country is higher than in other countries
Whether the exchange rate adjusts to restore lost price and cost
competitiveness for exporters
High and variable inflation usually creates more economic costs than
low and stable rates of price inflation
Volatile inflation – diverts resources towards protection from its
effects rather than a productive contribution to extra output
We can make a distinction between micro and macro-economic costs
of inflation
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Inflation leads to a re-distribution of income and wealth
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Loss of international competitiveness (when relative inflation is high)
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From lenders to debtors if real interest rates become negative
Away from those on fixed incomes or with weak bargaining power
Impact on exports (loss of market share)
Imports become relatively cheaper (rising import penetration)
Worsening of the international trade performance
Monetary policy response to high inflation –i.e. higher (nominal)
interest rates – which has negative effect on real output, investment
and employment
Loss of business confidence (lower planned investment) due to
uncertainty and lower expected real rates of return on capital
Shoe-leather and menu costs
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Hungary experienced hyperinflation on this scale
1939 Price Index (PI) = 100
Jan 1946
PI = 5,371,300
June 1946
PI = 19,686,163,000,000
A more recent example is Zimbabwe- where due to
Hyperinflation the currency became worthless.
When this happens, you need an alternative
currency, or you end up with a barter economy.
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Policies should focus on the causes of inflation:

Demand-pull inflation:
 Requires control of aggregate demand
 Aim: reduce the a positive output gap
 “Deflationary policies” to reduce real incomes and
spending

Cost-push inflation:
 Requires policies to control unit costs of production
 Policies that stimulate competition and keep prices
down in markets and industries
 Policies that increase aggregate supply potential in the
economy (in particular an increase in LRAS)

Demand-Pull Inflation
Higher interest rates
Increase in direct taxes such
as income tax
 Cuts in real level of
government spending
 If the Government runs a
Budget Surplus, this is a net
withdrawal from the
circular flow (helps to
reduce AD)
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
Cost-Push Inflation
Higher exchange rate
 Direct controls on wages
and prices
 Measures to stimulate
increased competition
 Policies designed to
increase labour
productivity (AS)

INTEREST RATE
CHANNEL
Expansionary
Monetary Policy
Lower Nominal
Interest Rates
Stimulates Capital
Investment
Increase in AD
BANK LENDING
CHANNEL
Expansionary
Monetary Policy
Increased
demand for credit
Stimulates
Consumer
Spending
Increase in AD
EXCHANGE RATE
CHANNEL
Expansionary
Monetary Policy
Exchange Rate
Depreciation
Stimulates Net
Exports
Increase in AD
WEALTH EFFECT
CHANNEL
Expansionary
Monetary Policy
Rise in Equity
Prices
Rise in Value of
Financial Wealth
Increase in AD
Rise in Land and
House Prices
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1993-2001 – a return to the low and stable inflation last seen in the
1950s and 1960s
Several factors explain the absence of inflation
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Subdued growth of wages and earnings (below 5%)
Absence of major inflationary shocks such as a sharp jump in
international commodity prices (although Oil in 2008 could have caused
this if it had continued
Success of Central Banks 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
Cuts in the prices charged by many of the privatised utilities
Expectations of inflation have fallen!
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Low stable inflation can provide a boost to economic
growth
 Easier for productivity improvements to show through in higher
real wages
 Gentle rise in prices boosts company earnings and gradually
erodes the real value of debt
 2-3% inflation gives some scope for relative prices to change in
the economy reflecting changes in supply & demand conditions

Price deflation
 A fall in the internal price level

Economy-wide deflation is rare but many individual examples
exist in specific industries and markets
 Farm prices in 1999-2001
 House prices in the early 1990s
 Coffee prices
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Shift in thinking of economic policy-makers (fearing a return to the inflation
of the 1970s and 1980s – widespread adoption of inflation targets)
Decline in inflation expectations. Consumers are now more price conscious
- harder to make price increases stick (increase in price elasticity of
demand?)
Change in the of the structure of the economy
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Declining importance of manufacturing (33% of GDP in 1970 down to 19% in
2000)
Long run decline in trade union membership – less upward pressure on real
wages
Impact of deregulation (higher market supply drives prices lower)
Intensity of price competition from the East - massive pool of cheap labour
aiming at the "inflationary weak spot of Western nations - manufacturing"!
The information & communication revolution (ICT) - can undermine
monopoly power through the costless transmission of price information –
but the impact of e-commerce should not be exaggerated