01/11/2010
Causes &
Effects of
Inflation
A2 Economics, November 2010
Causes of inflation
• Inflation is a sustained increase in the general level
of prices
• There are many possible causes of price inflation in
an economy – for example
1. Demand and supply-side causes
2. Inflation from internal and external sources
3. Inflationary effects of government / regulatory intervention
in the economy
• Average rates of inflation vary widely across the
world across countries at different stages of
development
1
01/11/2010
UK Consumer Price Inflation
Percent
The consumer
price
index
(CPI)
Annual % change
in the
Consumer
Price Index
6.0
6.0
5.0
5.0
4.0
4.0
3.0
3.0
CPI Inflation target = 2%
2.0
2.0
1.0
1.0
0.0
0.0
-1.0
-1.0
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
Source: UK Statistics Commission
Mapping the main causes of
inflation in the UK
Basic
Pay
Exchange rate
/ Profit margins
Import
Prices
Bonuses +
overtime
Global
Economic
Cycle
+
Earnings
Commodity
Prices
Unit labour
+
costs
+
=
Rate of
inflation
Productivity
Taxes
+
Economic
Cycle
Secular
Influences
(e.g. ICT
impact, quality
of education)
Fiscal Policy
Profit Margins
Economic Cycle
2
01/11/2010
Demand-pull inflation
• Demand – pull inflation
– When there is excess demand for goods and
services
– Positive output gap (where actual GDP >
Potential GDP)
– Businesses respond by raising prices to increase
profit margins
– Demand-pull
D
d ll iinflation
fl ti associated
i t d with
ith b
boom
phase of the cycle (SRAS becomes inelastic)
– Root causes of demand pull inflation are usually
monetary in origin (excessive lending / growth of
the money supply – monetarist causes)
Main causes of demand pull
inflation
• A large depreciation of the exchange rate
• A reduction in direct or indirect taxation
• Rapid growth of the money supply as a
consequence of increased bank and building
society borrowing
• Rising consumer confidence and an increase in the
rate of growth of house prices
• Faster economic growth in other countries –
providing a boost to UK exports overseas
3
01/11/2010
Illustrating demand-pull inflation
General
Price
Level
LRAS
SRAS1
P2
P1
AD2
AD1
Y1
Yfc Y2
National
Income
SRAS responds to excess
aggregate demand
General
Price
Level
LRAS
SRAS2
SRAS1
P3
P2
P1
AD1
Y1
Yfc Y2
AD2
National
Income
4
01/11/2010
Demand-pull inflation using a nonlinear AS curve
General
Price
Level
LRAS
P3
P2
P1
AD3
AD2
SRAS
AD1
Real National Income
Y2 Yfc
Y1
The Output Gap and Consumer Price Inflation
Per cent
Inflation
for
the- annual
UK% change in prices
Output Gap and
= Actual output
GDP - Potentialgap
GDP. CPI
inflation
10.0
10.0
8.0
8.0
6.0
6.0
4.0
4.0
CPI Inflation
2.0
2.0
0.0
0.0
Output gap
-2.0
-2.0
-4.0
-4.0
-6.0
-6.0
-8.0
-8.0
90
92
94
96
98
00
02
04
06
08
10
Source: UK Statistics Commission and OECD World Economic Outlook
5
01/11/2010
Cost Push Inflation
• Causes:
– External shocks ((i.e. commodityy price fluctuations))
– A depreciation in the exchange rate (higher import costs)
– Acceleration in wages / unit labour costs in the labour
market
• Leads to an inward shift in SRAS curve
• Firms raise prices to protect their profit margins –
better able to do this when demand is price inelastic
• “Wages often follow prices” - a second-round
effects of an increase in the cost of living
• Rise in actual inflation can lead to an increase in
inflationary expectations
Illustrating cost-push inflation
LRAS
SRAS2
General
Price
Level
SRAS1
P2
P1
AD1
Y2
Y1
Yfc
National
Income
6
01/11/2010
Illustrating cost-push inflation – with
a non-linear SRAS
LRAS
General
Price
Level
P2
P1
SRAS2
SRAS1
AD1
AD2
Y3
Y2 Y1
Yfc
Real National Income
UK Inflation and Crude Oil Prices
Oil
and
CPI
inflation
Annualprices
% change in the
Consumer
Price Index
and monthly average for Brent Crude
Percent
P
US
SD/Barrel
150
100
150
100
Crude Oil Price
50
50
0
0
6.0
6.0
5.0
5.0
4.0
4.0
Consumer Price Inflation
3.0
3.0
2.0
2.0
1.0
1.0
0.0
0.0
06
07
08
09
10
Source: UK Statistics Commission and IPE
7
01/11/2010
6
Wage Growth
and Consumer
Prices - A Link?
Average
Earnings
and Consumer
Annual % change in earnings and consumer prices
Prices in the UK
Percent
5
6
5
Average Earnings
4
4
3
3
2
2
Consumer price inflation
1
1
0
0
00
01
02
03
04
05
06
07
08
09
10
Source: Reuters EcoWin
200
Index
of have
UK Import
Prices
Import prices
can
a direct
Index 2003=100, source: Monthly Digest of Economic Statistics
effect on the rate of inflation
200
175
175
150
150
125
125
Index
Finished Manufactured Goods
100
100
Total Import Price Index
75
75
Import Prices for Fuels
50
50
25
25
01
02
03
04
Imports of Goods exc oil
Imports of Fuels
05
06
07
08
09
10
Imports of finished manufactures
Source: Reuters EcoWin
8
01/11/2010
Inflation
andexchange
the Exchange
for the UK
How
does the
rateRate
affect
Exchange rate index (top pane) and inflation (lower pane)
inflationary pressures?
110
110
100
100
90
90
80
80
70
70
Percent
P
IIndex
Sterling Exchange Rate Index
6.0
5.0
4.0
3.0
2.0
1.0
0.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
Consumer Price Inflation
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: Reuters EcoWin
Consequences
of inflation
9
01/11/2010
The costs of inflation
• ‘Taken together, the verdict of economics, history
and common sense is that inflation and deflation are
costly. It is clear that high inflation – in extreme
cases hyperinflation – can lead to a breakdown of
the economy. There is now a considerable body of
empirical evidence that inflation and output growth
are negatively correlated in high-inflation countries.
For inflation rates in single figures, the impact of
i fl ti on growth
inflation
th iis lless clear.’
l
’
• Mervyn King adapted from a speech entitled “The
Inflation Target – Ten Years On” given in 2002
Costs and Consequences of
Inflation (1)
• Money loses its value or real purchasing power
and people lose confidence in moneyy as the value
of savings is reduced
• Inflation can get out of control - price increases
lead to higher wage demands as people try to
maintain their living standards. This is known as a
wage-price spiral.
• Employees
p y
in p
poor bargaining
g
gp
positions lose out
and suffer a reduction in their real living standards
and relative income level (i.e. to other groups)
10
01/11/2010
Costs and Consequences of
Inflation (2)
• Inflation can favour borrowers at the expense of
savers – because inflation erodes the real value of
existing debts- if real interest rates are negative
• Inflation can disrupt business planning and lead
to lower capital investment
• Exporters may suffer – if prices in the UK rise higher
than those abroad – causing a deterioration in
global competitiveness
g
p
and a worsening
g of the
balance of payments position
• A possible cause of higher unemployment
• Rising inflation is associated with higher policy
interest rates - this reduces trend growth
Economic Growth and Inflation
UKUK
Economic
Growth
and
Inflation
Real GDP Growth
and Consumer
Price
Inflation. annual % change
10.0
10.0
7.5
7.5
Real GDP growth
Percent
5.0
5.0
2.5
2.5
Consumer price inflation
0.0
0.0
-2.5
-2.5
-5.0
-5.0
-7.5
90
-7.5
92
94
96
98
00
02
04
06
08
10
Source: UK Statistics Agency
11
01/11/2010
Anticipated inflation
• When people are able to make accurate
predictions of inflation
inflation, they can take
steps to protect themselves from its
effects
• For example, trade unions may exercise
their collective bargaining power to
negotiate with employers for increases in
money wages so as to protect the real
wages of union members
Unanticipated inflation
• Unanticipated inflation occurs when
economic agents (people,
(people businesses
and governments) make errors in their
inflation forecasts
• Actual inflation may end up well below, or
significantly above expectations causing
losses in real incomes and a
redistribution of income and wealth from
one group in society to another
12
01/11/2010
Inflation Expectations
Inflation expectations
Percent
Bank of England/NOP, how do you expect prices to change over the next 12 months?
6.0
6.0
5.0
5.0
4.0
4.0
3.0
3.0
2.0
2.0
1.0
1.0
0.0
0.0
04
05
06
07
08
09
10
How do you expect prices to change over the next 12 months?
How has prices changed over the past 12 months?
Source: Bank of England
Some Inflation Web Resources
13
01/11/2010
Join our Facebook Fan Page
Revision Workshops
14
01/11/2010
Tutor2u Economics
Keep up‐to‐date with economics, resources, quizzes and worksheets for your economics course. 15