a2 inflation and deflation

Inflation and Deflation Chapter 12:

Inflation and Deflation Chapter 12

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Inflation The most common way of measuring this in the UK is the CPI When the rate of inflation is published it means the percentage increase in the CPI over the previous 12 months (annual inflation) When we learn micro economics we see that prices go up and down all the time In macro we are describing a general movement of all prices The current CPI target is 2% plus or minus 1% This diagram shows recent UK data for both the RPI and the CPI The CPI excludes housing costs Inflation : a sustained increase in the general price level Consumer Price Index : the headline measure of inflation derived from movements in a weighted basket of consumer goods over a 12 month period Insert fig 12.1 P136

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The Consumer Price Index (CPI) The CPI is a weighted price index used to measure the change in the prices of a typical basket of goods and services The contents of the basket are changed each year using information from the Family expenditure Survey Changes in weighting reflects changes in spending behaviour (the more that is spent the higher the weighting) In 2008 fruit smoothies, muffins and USBs were included in the basket Microwaves, 35mm camera film and CD singles were removed Family Expenditure Survey : a representative monthly survey of UK household expenditure used to derive changes in the CPI

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Using index numbers This is straight forward if you can calculate percentage changes This table shows the made up index of house prices 2005 is the base year In 2006 there is an increase of 8.4% so the index goes up to 108.4 In 2007 there is an increase of 20% since 2005 so the index is 120.0 We need to take more care when working out the percentage change from 2006 to 2007 It is not 11.6% It is (120-108.4)/108.4 x 100 = 10.7% (Difference between the two years divided by the original year) Year Index 2005 100.0 2006 108.4 2007 120.0

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Limitations of the consumer price index as a measure of inflation Different population groups experience different rates of inflation The CPI is an average household and not representative of individual households The weighting for tobacco or motoring expenses will be irrelevant for non smokers and those without a car The CPI does not include house prices Mortgage prices will be a high proportion of spend of younger house buyers Many older home owners will have paid off their mortgages The CPI may overestimate inflation Price rises may hide improvements in the quality of goods and services Cars and electrical goods may have gone up in price but this is due to new innovations

Were you listening?!:

Were you listening?! Why might the CPI not be a good index to use?

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Causes of inflation Inflation comes from several sources It can come directly from the domestic economy Price strategies of leading food retailers based on the strength of demand or competitive pressures A rise in VAT cause firm’s production costs to go up and these being passed onto the consumer It can come from external sources Increase in price of crude oil or other imported commodities, foodstuffs and beverages Changes in exchange rates A falling pound against the Euro might cause higher import prices (remember WIDEC?)

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Causes of inflation The two main categories of inflation are? Cost push and Demand Pull What is Cost push? Things that cause production costs to go up and force firms to raise their prices to maintain profit margins A rise in costs of imported raw materials Rising labour costs Higher indirect taxes Wage price spirals Draw a diagram illustrating cost push inflation What is Demand pull? Most likely to occur when there is little spare capacity in the economy Increase in AD will lead to an increase in prices When does AD increase? When one or more of the components increases Draw a diagram illustrating demand pull At A2 we add a third type – excessive growth of the money supply Insert diagrams on P139

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Quantity Theory of Money Devised by Irving Fisher to explain the link between money and the general price level Based on the Fisher equation or the equation of exchange This is the mathematical identity which relates aggregate demand to the total value of output (GDP) M x V≡ P x T or (MV≡PY) M is the money supply V is the velocity of circulation (e.g. how many times a £20 note is used to buy goods and services in year) P is the general price level T stands for transactions and is equivalent to output Y is the real value of national output (real GDP) Quantity Theory of Money: the theory that increase in the money supply will lead to increases in the price level Velocity of circulation: the number of times the money supply changes hands in a year

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Quantity Theory of Money Monetarists argue that the velocity of circulation of money is broadly predictable and therefore assumed to be constant T and Y (real GDP) tends to increase slowly over time and thus is assumed to be constant in any one year If V and T (Y) are held constant then changes in the rate of growth of the money supply will lead directly to changes in the general price level So as money supply increases so does inflation Quantity Theory of Money: the theory that increase in the money supply will lead to increases in the price level Velocity of circulation: the number of times the money supply changes hands in a year Play duck inflation video

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Consequences of inflation Low and stable inflation is often seen as an indicator of a healthy economy Hyperinflation indicates an economy out of control There are a variety of consequences International competitiveness If inflation is higher in the UK than other international competitors UK goods and services will become less price competitive (ceteris paribus) Around 30% of the UK’s GDP is generated by exports and a similar value is imported The potential effect on growth, employment and the balance of payments is significant Exporting firms may need to make redundancies and revenues will fall If X reduces X-I will reduce which will reducing growth of AD and an output gap Examiner’s tip: try to remember the detail of three or four costs for consequences of inflation for your Unit 4 exam

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Consequences of inflation More consequences Effect on Investment Investment by firms needs future certainty and optimism Inflation causes uncertainty of costs, revenues and therefore profitability Investment levels may fall Poor investment over time will affect growth, employment and the balance of payments Menu costs This is the administrative cost of frequent changes in goods and services These costs may be passed on to the consumer contributing to cost push inflation

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Consequences of inflation More consequences Unanticipated inflation There is a difference between anticipated (expected) and unanticipated (not expected) inflation If people expect inflation of 2% but inflation is 4% there is unexpected inflation of 2% This is what leads to uncertainty that undermines investment Unanticipated inflation is likely to happen when inflation is unstable and high which is why the UK government tries hard to keep it low and stable

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Consequences of inflation More consequences Shoe leather costs When prices are rising consumers will spend more time, effort and possibly money shopping around This evokes the image of people pacing the high street but in reality consumers and firms are more likely to carry out the search by telephone or the internet. Effect on distribution of income An important source of economic injustice and social unrest Inflation creates winners and losers The winners are the borrowers whose future payment is fixed The losers will be savers who have a fixed return for example pensioners who will see their purchasing power fall The government could index link pensions and benefits to make sure they are in line with inflation

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Consequences of inflation More consequences Worsening industrial relations Friedman’s comment is very melodramatic but it is true that strikes can be widespread during periods of inflation Workers feel that they are losing out and fight for more pay Fiscal drag When every you see the word ‘drag’ think about something dragging behind This is about tax allowances being behind inflation; it is not keeping up with inflation and people are worse off If someone has a tax allowance of £5000 and earns £5000 they will pay no tax If prices rise by 10% and income rises the same amount that person will then be paid £5,500 They will now be taxed around 20% of the £500 (£100) and therefore be worse off The chancellor can increase the tax free allowance in line with inflation ‘Inflation tears at the fabric of society and sets up groups of workers against one another in increasingly violent conflict’ – Milton Friedman Fiscal drag : increases in the burden of taxation when tax allowances are not increased in line with inflation

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Consequences of inflation - Hyperinflation Usually regarded as inflation in excess of 1000% per year The currency is effectively destroyed and cannot be used as a medium of exchange or a store of value The economic system would resort to barter See Zimbabwe video

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Can inflation be a good thing? Allen says that low predictable levels of inflation provide psychological incentives for firms and individuals At inflation rates of around 2% workers see some rise in pay (in money terms) Firms see revenues increasing This could be pure money illusion It is felt to be preferable to no price increases Money illusion : when economic agents fail to realise that changes in money values are not the same as changes in real values ‘ Creeping inflation lubricates the wheels of industry’ – G.C.Allen

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Can inflation be a good thing? In reality 0% inflation and a 0% wage is the same as 2% inflation and a 2% pay rise Psychologically the second option is preferred The target of 2% plus or minus 1% suggest that It is difficult to hit a target with any accuracy There must be reasons why governments prefer gentle inflation It is seen as equally bad if you undershoot the target as it is to overshoot the target

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Deflation Are falling prices a good thing? Deflation is a fall in the general price level (not falls in a few specific prices) There are two types of deflation Benign Malevolent Malevolent is the problem AD falls Money supply falls Unemployment is likely to increase Further reductions in spending This can bring about a negative multiplier effect and tip the economy towards recession Benign deflation : falling prices resulting from technological advances across the economy Malevolent deflation : falling prices resulting from a significant downturn in economic activity

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Deflation Japan has a problem with deflation Banks collapsed due to bad debts and bad investments in their own stock market People built up precautionary savings in case they lost their jobs This depressed consumption and AD Interest rates were cut to 0.25% but it didn’t work The damage had been done Consumer and business confidence crumbled with people and firms reluctant to spend Don’t confuse a decrease in inflation (a decrease the rate of inflation) with deflation (an actual fall in the level of prices) Play Japan Inflation video Benign deflation : falling prices resulting from technological advances across the economy Malevolent deflation : falling prices resulting from a significant downturn in economic activity

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Complete exam style questions (all) P145