AS Macro Revision: Inflation and Deflation

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Information about AS Macro Revision: Inflation and Deflation

Published on February 21, 2014

Author: tutor2u


AS Macro Revision Inflation and Deflation Spring 2014

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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 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 Rate in the UK Economy in Recent Years A lower inflation rate means prices rise more slowly Inflation in the UK has been persistently above target for most of the last eight years

How is the Rate of Inflation Calculated? • Inflation is measured by the consumer prices index (CPI) and the retail price index (RPI) • A base year is selected for price information and a family expenditure survey is carried out • A representative basket of goods and services used and weights are attached to each item - based on items’ importance in people’s expenditure • Each month government officials collect 120,000 separate price quotations in 141 locations of around 600 products • Weights are multiplied by price changes - the weighted price changes are then totalled to calculate the inflation rate At the beginning of each year the weights used to compile both the CPI updated using the latest information on household spending

The Weights in the Consumer Prices Index (2013) Brought into CPI in 2013 • White rum • Continental meats • E-readers • Daily disposable contact lenses • Hot chocolate Taken out of CPI in 2013 The “shopping baskets‟ of items used in the Consumer Prices Index (CPI) are reviewed each year. Some items are taken out of the baskets and some are brought in to make sure the CPI is up to date and representative of consumer spending patterns • Champagne • Gas barbeques • Pairs of soft contact lenses • Round lettuces

Limitations of CPI as a Measure of Inflation Not all 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. Housing costs: The ‘housing’ category of the CPI measures changes in the costs of rents, property and insurance, repairs. It accounts for around 16% of the index. Housing costs vary greatly from person to person e.g. Young people in rented property 4. Changing quality of goods and services: Although the price of a good or service may rise, this may also be accompanied by an improvement in quality as the product 5. New products: The CPI is quite slow to respond to the emergence of many new products and services

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The Main Causes of Inflation Demand Pull inflation • Caused by excess aggregate demand • Often linked to money and credit boom • Economy close to full capacity (inelastic AS) • Positive output gap (AD > potential GDP) Inflation Expectations 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 Most agents in the economy (workers, businesses, le nders) will raise their inflation expectations and build it into their calculations and decisions

Cost-Push Inflation using AD-AS Diagram Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit margins Can be caused by: 1. Rising unit labour costs 2. Higher costs of 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 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, AS 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 Global inflation in commodity prices Boom in credit / money supply Rise in business taxes e.g. VAT A depreciation of the exchange rate High inflation in other countries

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Analysis: 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

Economic Recovery and Inflation in the UK In recent years the rate of inflation has been higher than real GDP growth – but inflation is now falling as the economy recovers Some reasons for falling inflation as the UK economy recovers: 1. Commodity prices have been declining 2. Wages continue to grow slowly 3. Stronger currency 4. Negative output gap

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

Price Deflation Deflation is defined as a persistent fall in the general price level of goods and services. The rate of inflation becomes negative. GPL AS1 AS2 GPL1 GPL2 AD1 AD2 Y2 Y1 Real GDP Demand-side causes • Deep fall in AD causing a persistent recession • Large negative output gap – high spare capacity Supply-side causes • • • • Improved productivity Technological advances Significant fall in wages High exchange rate

Possible Economic Consequences of Deflation • Holding back on spending: Consumers may postpone demand if they expect prices to fall in the future • Debts increase: The real value of debt rises with deflation and higher real debts can be a drag on consumer confidence • The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices. • Lower profit margins: Lower prices can mean reduced revenues and profits for businesses - this can lead to higher unemployment as firms seek to reduce their costs by shedding labour. • Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence • Income distribution: Deflation leads to a redistribution of income from debtors to creditors

Economic Policies to Avoid Price Deflation The main approach to avoiding deflation is to use stimulus policies either by loosening monetary policy and/or fiscal policy Low interest rates and quantitative easing • Cheaper loans for businesses and households • Expanding the supply of credit in banking system Fiscal stimulus • Higher government spending (e.g. Capital projects) • A rise in government borrowing Other measures to stimulate demand • Attempts to lower the value of the exchange rate • Higher taxes on savings to encourage consumption

Tackling Deflation – Abenomics in Japan For many years the Japanese economy has struggled to break free from a combination of weak growth and price deflation Easing monetary policy • Attempt to devalue Yen • Higher inflation target (2%) Fiscal stimulus • Big rise in capital spending The reflationary policies introduced into the Japanese economy in recent years have been given the name Abenomics after the Prime Minister who launched them. There are three main “arrows of policy” designed to boost demand, output, jobs and prices. Structural reforms • Designed to increase competition and productivity

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