Inflation

1. Inflation This presentation considers the recent record on inflation in the UK economy. Why has inflation remained so low? What are the economic consequences of inflation? And what economic policies are most effective in keeping inflation in check? Recent Trends in UK Inflation

2. Inflation – the fundamentals • Inflation is a sustained increase in the general level of prices (as measured by a consumer price index) • Inflation rate is the annual % change in prices • A rise in the price level means a fall in the internal purchasing power / value of money • The rate of inflation varies over time • 1950s and 1960s – low stable inflation • 1970s and 1980s – UK inflation was volatile • 1990s – much lower average inflation • 2000 – the lowest rate of inflation for over twenty years

3. Retail Price Inflation

4. Degrees of Inflation • Deflation • Creeping inflation • Accelerating Inflation • Hyper-inflation • Disinflation

5. Retail Price Index (RPI) • The RPI is a weighted index of prices • The RPI measures the general level of prices • Measures the cost of living for a household with average spending patterns • Weights in the index are determined by relative spending patterns • These patterns change over time – so the weights are changed to reflect this • Over 600 items in the basket of goods and services • Retail prices are measured every month – an enormous sample is taken

6. Limitations of the Retail Price Index • RPI measures the rate of inflation over the preceding twelve months - a retrospective figure • RPI is distorted by changes in administered prices • changes in indirect taxation • price controls on privatised utilities • RPI rarely reflects changes in the cost of living of many different economic households • pensioners • students • households of below average income

7. Measures of Inflation • Retail Price Index (RPI) • All-item RPI "Headline Rate" • RPIX "Underlying Rate" • RPIY "Core Inflation" • Harmonised Index of Consumer Prices (HICP) • Producer Price Inflation (PPI) • Also known as factory gate inflation • Unit Labour Cost Inflation (ULC’s) • Labour costs per unit of output produced • Input Price Inflation • Costs of energy, raw materials and components used in production

8. 4 Measures of Inflation in the UK (1997-2001)

9. Underlying Inflation - RPIX Very low and stable inflation during the last eight years – with RPIX inflation hovering around the 2.% mark for most of this period Surge in inflation between 1988-90 because of the economic boom followed by the inflationary shock of the Gulf War

10. Harmonised Index of Consumer Prices The harmonised index of consumer prices is a standardised measure of inflation used by countries inside the European union

11. The Inflation Target Inflation targets have been in existence in the UK since October 1992. In May 1997 the Labour Government introduced a target of 2.5% (+/- 1%) for RPIX inflation

12. Goods and Services Highly competitive pressure in many goods markets encouraged by the strong pound (which makes imports cheaper) has led to a sharp decline in goods price inflation

13. Inflation and Deflation Genuine deflation (falling prices) is happening in several sectors of the economy.

14. Main Causes of Inflation • Inflation has two main causes • Demand – pull inflation • 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) • Companies respond by raising prices to increase their profit margins • Cost – push inflation • When costs of production are increasing • 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

15. Demand Pull Inflation As SRAS becomes more inelastic, the trade-off between real GDP growth and inflation worsens General Price Level SRAS P3 P2 P1 AD3 AD2 AD1 Y3 Y2 Y1 Real National Output

16. Root causes of Inflation Exchange rate / Profit margins Import Prices Basic Pay Bonuses + overtime Global Economic Cycle + Commodity Prices Earnings Unit labour costs = + RPIX inflation + Productivity Taxes + Fiscal Policy Secular Influences (e.g. ICT impact) Economic Cycle Profit Margins Economic Cycle

17. The Costs of Inflation • Economic costs of inflation depend on • The degree of inflation • Whether inflation is • anticipated • unanticipated • Whether inflation in one country (e.g. the UK) is higher than in other countries • Whether the exchange rate adjusts to restore lost competitiveness for exporters • High and variable inflation usually creates more economic costs than low and stable rates of price inflation

18. The Main Economic Costs of Inflation • Arbitrary re-distribution of income and wealth • From lenders to debtors if real interest rates become negative • Away from those on fixed incomes • From tax-payers to the government because of fiscal drag • Loss of international competitiveness • Impact on UK exports (loss of market share) • Imports become relatively cheaper (rising M penetration) • Worsening of the UK’s international trade performance • Higher nominal interest rates (via Bank of England) • Loss of business confidence (lower planned capital investment) • Shoe-leather and menu costs

19. UK and G7 Inflation G7: USA, Germany, Japan, UK, France, Canada and Italy UK G7 For most of the last 20 years, UK price inflation has been greater than the G7 average – but the UK’s relative inflation performance has certainly improved recently

20. Economic Policies to Control Inflation • Focus on the causes of inflation: • Demand-pull inflation: • Requires control of aggregate demand • “Deflationary policies” to reduce 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)

21. Demand-Pull Inflation Higher interest rates (Bank of England independence 1997) Increase in direct taxes such as income tax Cuts in real level of government spending Budget Surplus is a net withdrawal from the circular flow Cost-Push Inflation Higher sterling exchange rate Direct controls on wages and prices Measures to stimulate increased competition Policies designed to increase labour productivity (AS) Controlling Inflation (2)

22. Interest Rates and the Bank of England

23. Increase in Economic Activity Expansionary Monetary Policy Lower Interest Rates Stimulates Capital Investment Stimulates Consumer Spending Increase in Economic Activity Expansionary Monetary Policy Increase in Bank Loans Expansionary Monetary Policy Exchange Rate Depreciation Increase in Economic Activity Stimulates Net Exports Expansionary Monetary Policy Rise in Equity Prices Increase in Economic Activity Rise in Value of Financial Wealth Rise in Land and House Prices Channels of Monetary Policy INTEREST RATE CHANNEL BANK LENDING CHANNEL EXCHANGE RATE CHANNEL WEALTH EFFECT CHANNEL

24. Controlling demand-pull inflation General Price Level SRAS P2 P3 P1 AD2 AD3 AD1 Y1 Y3 Real GDP Y2 Deflationary policies seek to reduce aggregate demand and control inflation

25. Increasing aggregate supply helps to cut prices General Price Level SRAS1 SRAS2 P3 P2 P1 AD2 AD1 Y1 Y2 Real GDP Y3 An increase in AS might be caused by higher productivity of factors of production

26. Explaining low inflation in the UK economy • 1993-2001 – a return to the low and stable inflation seen in the 1950s and 1960s • Several factors explain the absence of inflation • Subdued growth of wages and earnings (below 5%) • Absence of major inflationary shocks such as 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 information technology has helped to reduce costs • Cuts in the prices charged by many of the privatised utilities

27. Death of Global Inflation? • Shift in thinking of economic policy-makers (they fear a return to the inflation of the 1970s and 1980s) • Decline in inflation expectations. Consumers are now more price conscious and more resentful of price increases than they were • Change in the of the structure of the economy • Declining importance of manufacturing (33% of GDP in 1970 down to 22% in 1996) • Long run decline in trade union membership – less upward pressure on wages • Weakening of the role of the state in economies due to privatisation and deregulation of product markets. • Competition from the East - massive pool of cheap labour aiming at the "inflationary weak spot of Western nations - manufacturing"! • The Information revolution - can undermine monopoly through the costless transmission of price information

28. UK and European Inflation Inflation in the UK has been below that of the Euro Zone average for over 18 months. European inflation has been boosted by the sharp fall in the external value of the Euro