Inflation Measurement and Causes

AS Economics

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Areas to focus on

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Key Issues
The meaning of inflation Measuring the general price level Deflation and hyperinflation Causes of inflation (demand pull and cost push) Controlling inflation demand and supply-side policies Recent trends in UK inflation Why has inflation in the UK remained so low?

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Defining inflation
Inflation is a sustained increase in the average price level of a country. The rate of inflation is measured by the annual percentage change in the level of prices as measured by the consumer price index. A sustained fall in the general price level is called deflation in this situation, the rate of inflation becomes negative.

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What are the main causes of inflation?

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Watch this & make notes on what have been the causes of inflation

Two types of causes of inflation

Demand pull inflation Cost push inflation

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Demand pull inflation

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Demand-pull inflation
Occurs when there is excess AD i.e. when there is a positive output gap (actual GDP > Potential GDP) Businesses respond to high demand by raising prices to increase their profit margins Demand-pull inflation is associated with the boom phase of the cycle (when SRAS becomes inelastic) The main causes of demand pull inflation
Very fast growth of demand for credit / borrowing High levels of consumer spending

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Draw a Classical AD/AS diagram

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Draw a Classical AD/AS diagram

LRAS Price Level

What would happen if there was an increase in AD in the SHORT RUN?

AD

Y1

Real National Output

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Draw a Classical AD/AS diagram

LRAS Price Level

SRAS

How can an economy operate beyond its Full employment level?

AD1 AD

Y1

Y2

Real National Output

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PPF represents an economys capacity!

How can an economy operate beyond its Full employment level?

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Draw a Classical AD/AS diagram

LRAS Price Level

SRAS

In the SR the economy can work overtime, at a slightly higher cost (overtime)
AD1 AD

Y1

Y2

Real National Output

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Draw a Classical AD/AS diagram

SRAS2 LRAS Price Level

SRAS

AD1 AD

In the LR, workers are not willing to sacrifice Leisure time for more overtime. But still have high wage expectations. demand pull inflation

Y1

Y2

Real National Output

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To your notes..
Draw the AD/AS diagram (s) and add your own explanation of what happens

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Main causes of demand pull inflation

A depreciation . A reduction in direct or indirect taxation Rapid growth of the money supply Rising consumer confidence Faster rates of economic growth in other countries

How can each of these cause inflation?

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Main causes of demand pull inflation

A depreciation of the exchange rate increases the price of imports and reduces the foreign price of UK exports A reduction in direct or indirect taxation - consumers will have more disposable income causing demand to rise 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 rates of economic growth in other countries providing a boost to UK exports overseas (an injection of AD)

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Cost push inflation

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Cost Push Inflation

Occurs when costs of production are increasing Causes:
External shocks (commodity price fluctuations) A depreciation in the exchange rate Acceleration in wages

Leads to inward shift in SRAS curve

Firms raise prices to protect their profit margins better able to do this when market demand is price inelastic Wages often follow prices A rise in inflation can lead to rising inflationary expectations
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Draw an Classical AD/AS diagram

LRAS Price Level SRAS2

SRAS1

What would happen if there was an inward shift of the SRAS?

AD

Y2

Y1

Real National Output

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Wage inflation in the UK economy

Earnings and prices
Annual percentage change in earnings and consumer prices 11 10 9 8 7
Percent

Average Earnings

6 5 4 3 2 1 0 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 Consumer price inflation

Average earnings

Consumer Price Inflation [ar 12 months] Source: Reuters EcoWin

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Cost push inflation falling SRAS

LRAS Price Level

SRAS2

SRAS

Yfe

Real National Output

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Illustrating cost-push inflation

LRAS Price Level

P2 Pe

SRAS2

SRAS AD1

Y2

Y1

Yfe

Real National Output

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Costs and Consequences of Inflation

Money loses its value and people lose confidence in money 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. Consumers and businesses on fixed incomes lose out because the their real incomes falls - employees in poor bargaining positions lose out
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Consequences of growing inflation

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Costs and Consequences of Inflation

Inflation can favour borrowers at the expense of savers because inflation erodes the real value of existing debts Inflation can disrupt business planning and lead to lower capital investment Inflation is a possible cause of higher unemployment in the long term because of a lack of competitiveness Rising inflation is associated with higher interest rates this reduces economic growth and can lead to a recession
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Explaining low inflation in the UK

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Explaining low inflation in the UK

Several factors explain the absence of inflation
Subdued growth of wages and earnings (below 5%) Absence of major inflationary shocks such as a sharp jump in international commodity prices Success of the Bank of England 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 technology has helped to reduce costs Cuts in the prices charged by many of the privatized utilities Expectations of inflation have fallen!
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The NICE-1990s!
In the 1990s, the UK experienced a noninflationary consistently expansionary - or "nice" - decade; a decade in which growth was a little above trend, unemployment fell steadily, and cheaper imports allowed consumers to enjoy rising living standards without the need to ask for inflationary pay claims Mervyn King, Governor of the Bank of England

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Interest rates and inflation

Consumer Price Inflation and Interest Rates for the UK
Annual percentage change in the UK Consumer Price Index, the inflation target is 2%

8 7 6 Base Interest Rates 5

Percent

4 3 CPI Inflation 2 1 0 97 98 99 00 01 02 03 04 05 06

UK Consumer Price Inflation [ar 12 months]

Base Interest Rates for the UK

Source: Reuters EcoWin

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A decline in global inflation

World Inflation
Annual percentage change in consumer prices, source IMF World Economic Outlook

35

30

25
Percent per Annum

20

15

10

0
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

Source: Reuters EcoWin

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Reasons for continued low inflation

Increased competition in markets Success of Bank of England in controlling AD Strong exchange rate has kept import prices low

Low Inflation in the UK Economy

Effects of globalisation cheaper imports tutor2u

Rising productivity & new technology

A fall in workers expectations of inflation

Homework
Read article about Economic Cycle Highlight key issues use 2 different colours highlight positives & negative issues Make a summary of the key issues raised Complete Q 1, 2 & 4 only.

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Further knowledge
http://www.bbc.co.uk/iplayer/episode/b00r92bp/Select_ Committees_Inflation_Report_Committee/ If you are really interested in what happens with the BoE in managing inflation watch this select committee meeting. Listen to this reasons why inflation can be good for the economy

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Some quick questions

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Inflation Qs
What is meant by Inflation? (2) Explain how inflation is measured? (2) Explain how a fall in the rate of unemployment might effect the rate of inflation? (8 marks) Using AD/AS analysis, assess the implications of a fall in AD on the UK economy? (8 marks)
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