Inflation

A sustained rise in the general price level.

·         Has to be general/average price level as some prices may rise and some fall.

·         A fall in the value of money – wages become less valuable.

·         Basket of goods > 700 products > each product is given a weight > most commonly bought is the heaviest > monitor price changes 120,000 prices > weight x price change > done by a weighted price index.

·         Weighted price index:
To calculate the average price rise you need weightings – what people spend money on, found out by using the family expenditure survey (basket of goods).
What happens to prices over that period.
Multiply weights by price changes.

·         Creeping – less than 10% p.a.

·         Severe – 10-100% p.a.

·         Galloping – 100-1000% p.a. e.g. Zimbabwe 2007.

·         Deflation – prices falling e.g. Japan.

·         Cost push inflation:
Increases in cost of production leads to an increase in the price of a product.
Most important cost of production for most firms is wages.

·         Demand pull inflation:
The demand for goods and services pulls the prices up.
Increase in demand leads to an increase in prices.

·         Mixture of the two: wage price spiral.

·         Too much money chasing too few goods: Monetary theory.

·         Expectational inflation.

Controlling inflation is important because low and stable inflation is believed to be a key requirement for creating the right conditions for growth in an economy.

Anticipated inflation (stable, predictable, steady): the actual rise in general price level is close to what is expected.

Unanticipated (larger than expected jump): actual rise in inflation is higher than expected – more damaging than anticipated because it increases uncertainty.

·         Uncertainty: low confidence
Firms: if firms are uncertain about the future they might react by making redundancies
Consumers: worry that further unanticipated inflation may reduce the value of their income and savings > respond by reducing their consumption in order to save and create a buffer > falling demand leads to lower output and unemployment.

·         International competitiveness: less of it
As UK price level rises relative to that in other countries, demand for exports falls whilst the demand for imports rises.
Leads to a fall in UK competitiveness.
This effect may well be offset by a fall in exchange rate – which may cause further inflation as the price of imports rises.

·         Fiscal drag:
If money wages rise with inflation but tax bands do not, proportion of income taken in tax will rise, consequently the economy will slow down.

Confusion in the price mechanism:
difficult to distinguish whether a price rise is due to general inflation of is a genuine increase relative to other goods.
Producers and consumers may make the wrong interpretation and decisions.

·         The cure depends on the cause/type.

·         Fiscal policy – government expenditure and taxation.
reduced demands for goods and services by increasing taxes on income>less disposable income = less spending
reduce the government expenditure>govt. is the biggest spender in the UK>£587 billion in 2007/8

·         Monetary policy – cost and supply of money
MPC at BoE increases interest rates>target 2%>increase in IR leads to increased saving, reduced consumption, reduced borrowing, increased mortgage repayments.

·         Supply side policy:
increasing the amount of goods and service available
increasing incentives to work
Increasing incentives to produce
increasing entrepreneurship and risk-taking

·         Wage restraint – anti TU legislation

·         Reduce inflation expectations