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Topic 5: Inflation
1
Definition
• Inflation is a rise in the general level of prices. It does not mean that all
prices are rising; some may rise while others fall or stay the same.
• The rate of inflation is the percentage increase in the general l evel of
prices in a period of time.
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How is the general level of prices measured?
2.1
The Government measures changes in the prices of a number of different
groups of goods and services and it publishes a number of price indices. Three
such price indices are:
2.2
(a)
RPI – the Retail Price Index – the ‘headline rate of inflation’.
(b)
RPIX – the RPI without mortgage interest payments – the ‘underlying
rate of inflation’.
(c)
Consumer Price Index – the RPI without housing costs and council tax
costs – this is the measure now used by the UK Government to
calculate the rate of inflation.
Retail Price Index. The RPI is a weighted average of the prices of those
goods and services most commonly bought by households in the UK.
It is calculated in the following way:
(a)
(b)
(c)
(d)
The Family Expenditure Survey is used to identify a basket of the
products bought by the majority of households.
Each item in the basket is weighted according to the amount of spending
on it, e.g. if 5% of consumer spending went on pet rol then it would have
weighting of 5%.
A point in time is chosen as the base for the index.
Each month the price of each item is compared and expressed as a
percentage of its price at the base date. This price is called a price
relative, e.g. if petrol increased in price from 50p per litre at the base
date to a current price of 70p per litre it would have a price relative of
140.
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Higher Grade Economics
Unit 5 Summary (Inflation)
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(e)
(f)
(g)
The price relative is multiplied by its weighting and it would be included
in the index as 140 x 5% = 7.
This calculation is repeated for each item and the figures are added to
give the weighted average total.
Notice that the RPI at the base date would be 100.
Although no longer used by the UK Government to measure the general level
of inflation it still uses changes in the RPI to uprate benefit levels.
2.3
RPIX. The Government believed that measuring changes in the RPIX was a
better measure of inflation for the following reason.
The RPI includes mortgage costs which depend on interest rates. In recent
years the change in interest rates has been the main policy weapon used by UK
governments to control inflation. Increasing interest rates reduces inflation.
However, a rise in interest rates has the more immediate consequence of
raising mortgage costs and the RPI (seemingly the opposite of what was
intended). Excluding mortgage interest payments and using RPIX gave policy
makers a better guide to how well their anti -inflation policy was working.
2.4
Consumer Price Index. In 2003 the Government introduced this new index.
Its official title is the Harmonised Index of Consumer Prices but this mouthful
is usually referred to as the Consumer Price Index.
What is it?
It is similar to the RPIX. Both give a measure of the changes in the cost of
buying a representative basket of goods and services. But the main difference
is that where the RPIX excluded mortgage payments, the CPI will exclude
mortgage payments and other housing costs such as repairs, insurance and
council tax.
Why the switch?
The main reason is that the CPI is closer to the method used in the rest of the
EU and this will make it easier to compare the UK inflation rate with the rest
of the EU. This is an important part of judging when would be the right time
for Britain to join the euro.
The Government is now using changes in the CPI, instead of the RPIX, as its
measure of inflation.
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Higher Grade Economics
Unit 5 Summary (Inflation)
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2.5
Calculating the rate of inflation. Using the CPI the annual rate of inflation is
calculated each month: e.g. if the CPI was 500 on 30 September 2003 and 525
on 30 September 2004 then the rate of inflation would be 5% (25 ÷ 500 x
100).
The formula is: (Current index – Last index)/Last index x 100
A note of caution
The rate of inflation measures the rate at which prices are increasing; e.g. a
rate of inflation of 3% means that on average prices are rising by 3%. A fall in
the rate of inflation does not mean that prices are falling but that they are
rising at a slower rate; e.g. if the rate of inflation fell to 2%, this means that
prices are now rising at 2% rather than 3%.
Year 1
Price index
at Jan 1
100
Price index
at 31 Dec
102
Year 2
102
106
Annual rate of
inflation
(102 – 100)/100
 100 = 2%
(106 –102)/102
 100= 3.9%
Comment



Year 3
106
107
= 0.9%


Year 4
107
107.96
= 0.9%


Bannerman High School
Higher Grade Economics
Unit 5 Summary (Inflation)
Price level
increased by 2%
Price level
increased by 3.9%
Rate of inflation
increased from 2%
to 3.9%
Price level
increased by 0.9%
Rate of inflation
decreased from
3.9% to 0.9%
Price level
increased by 0.9%
Rate of inflation
stayed constant
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Harmful effects of inflation
3.1
On individuals
(a)
It reduces the standard of living of those whose incomes are fixed or
which do not rise as fast as the rate of inflation. Their real incomes fall
as money loses its purchasing power.
(b)
It reduces the disposable incomes of those on low wages because an
increase in their money wage arising from inflation may make them
liable for income tax and they may also lose means-tested social
benefits. This is called fiscal drag.
(c)
It reduces the real value of savings if the interest rate is less than the
inflation rate. If the real rate of interest is negative then a saver will
lose. The rate of interest quoted on savings is called the nominal rate of
interest. The real rate of interest is the nominal rate adjusted for
inflation.
Real rate of interest = Nominal rate of interest – rate of inflation
e.g. with a nominal rate of 8% and a rate of inflation o f 12%, the real
rate would be –4%.
However, even when the purchasing power of savings is falling people
still save. Why is this?
• Much of their saving is habitual.
• Much saving is contracted into for long periods of time. It is not easy
for savers to get out of insurance or pension fund contracts.
• People need to save if they wish to buy a product which they cannot
afford out of one week’s income.
• Many people are ignorant of the effects of inflation on the real value
of their savings.
(d)
It causes unemployment because:
• wage inflation may force some firms to reduce their labour costs by
laying off surplus labour in order to remain competitive.
• reduced competitiveness in domestic and foreign markets may force
firms out of business.
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3.2
3.3
On firms
(a)
It reduces the real value of profits of firms which operate in markets
where there is foreign competition. Foreign competitors may produce in
economies where inflation is lower. UK firms may not be able to raise
their prices sufficiently to cover inflated costs.
(b)
It reduces the willingness to invest. Inflation creates uncertainty about
future costs and prices – firms uncertain about the future profitability of
a new project may cancel any plans to invest. This will also cause
unemployment both within the firm and for workers in firms which
supply machinery and components.
(c)
It encourages inefficiency. Firms which operate in markets where there
is little competition may be able to mask inefficiency by raising prices.
On the economy
(a)
The balance of payments may deteriorate. If the rate of inflation is
higher than that in other countries then this leads to:
• dearer exports which become less attractive to foreign buyers.
• cheaper imports which become more attractive to domestic buyers.
(b)
It reduces economic growth if firms are discouraged from investing (see
3.2 (b) above).
(c)
It distorts the balance of taxation. The balance between direct and
indirect tax may be distorted because:
• income tax revenue rises automatically with inflating incomes.
• expenditure taxes, e.g. excise duties which are fixed in money terms,
tend to fall in real value.
(d)
A period of inflation creates an expectation that it will continue and this
expectation will ensure that it does, e.g. if worker s expect inflation to be
5% in the coming year, they will demand a 5% increase in pay this year
in order to protect the real value of their incomes. If this increase in pay
is not matched by an increase in productivity then employers will be
faced with increased costs and will increase prices, thus causing the very
inflation which
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workers expected. This then confirms the expectation and so the process
continues.
(e)
It threatens the use of money in countries where hyper -inflation renders
money worthless.
Advantages of inflation
Not everyone suffers from inflation. Some parts of society may actually
benefit from it.
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(a)
Borrowers gain because they have the use of money now when its
purchasing power is greater.
(b)
Some firms are able to increase prices and profits before they pay out
higher wages.
(c)
The government finds that people earn more and so pay more income
tax.
Causes of inflation
Disagreement exists among economists and politicians about the causes.
There are basically two schools of thought:
(1) Keynesianism, and (2) monetarism.
Keynesianism
Keynesians believe that there are three possible causes of inflation:
(a)
Demand–pull inflation which is caused by a desire by citizens, firms or
government to spend excessively.
(b)
Cost–push inflation which is caused by increased production costs.
(c)
Expectations of inflation.
Monetarism
Monetarists believe that inflation is the result of an excessive growth in the
money supply.
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4.1
Keynesian demand–pull inflation. This arises when the economy is booming
and when aggregate demand is greater than full employment output. Output
cannot be increased, prices rise in response to the excess demand.
Demand–pull inflation may occur in particular sectors of the economy even
when there is less than full employment in the whole economy, e.g. it may
arise when demand exceeds supply in an area of the country such as the south
east. House prices, land prices, wages, etc. may rise, which then spreads to
other parts of the country.
4.2
Keynesian cost–push inflation. If costs of production increase faster than
productivity then this will lead to increases in unit costs. If producers wish to
maintain their margin of profit between price and unit cost they have to
increase prices. This type of inflation may occur even when the economy is
not at full employment.
Reasons for cost increases
• increases in the cost of raw materials
• increases in the price of energy
• increases in wage rates
• fall in the exchange rate of the £ which increases the prices of imported
materials and energy.
4.3
Expectations of inflation. See para. 3.3 (d) above. This is sometimes referred
to as a wage–price spiral, in which inflation becomes a permanent feature of
the economy.
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Monetarism
5.1
The quantity theory of money
Monetarism is the belief that increases in the money supply which are greater
than increases in output lead to increases in prices. Monetarism was
developed in the 1950s by a famous American economist, Milton Friedman,
and is based on the quantity theory of money. The quantity theory of money as
developed by Friedman states that:
MV = PQ
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where:
M = the money supply
V = the velocity of circulation, i.e. the number of purchases made
in a period of time
P = the price level
Q = the quantity of output per period.
Monetarists believe that the velocity of circulation is stable, e.g. in simple
terms they think that the number of shopping trips we make is constant from
year to year. Any increase in the money supply which is greater than t he
increase in output causes the price level to rise.
5.2
The money supply
In a modern economy, money consists of:
(a)
(b)
(c)
coins
bank notes
bank deposits, which nowadays are the most important form of money.
Bank deposits are entries in banks books which are created when a customer
deposits money or when a bank gives a loan. Bank deposits are transferred
between debtors and creditors by cheque, standing order, direct debit or by
electronic means (Switch, etc.). There are many different kinds of b ank
deposit distinguishable by how much notice has to be given before they can be
withdrawn.
Increases in the supply of money
There are two major causes:
(a)
(b)
5.3
Bank lending. Interest on bank loans is a major source of income for a
bank and banks will therefore lend as much as they prudently can.
Government borrowing from banks. You will find out in Topic 4 that
governments often spend more than they take in tax revenue and
therefore have to borrow. If they borrow from banks it increases the
banks’ ability to lend even more money to their customers. For Higher
Economics you do not need to know how this process works.
Monetarists then believe that excessive bank lending or government borrowing
from banks are major causes of inflation. Once inflati on is in
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the economy, as with the Keynesian view, expectations of inflation cause
further inflation.
Monetarists believe that demand–pull and cost–push inflation are both
symptoms rather than causes of inflation since both result from excessive
growth in the money supply.
(a)
Demand–pull, they say, results from excessive credit (money supply)
being available to consumers and firms which increases their purchasing
power.
(b)
Cost–push can only be passed on in higher prices if firms have access to
cheap excess credit – i.e. they borrow to cover increased costs and pass
on the borrowing costs to customers.
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Higher Grade Economics
Unit 5 Summary (Inflation)
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Section 6 is for Higher only
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The inflation record since 1990
Retail price inflation
Headline inflation (annual % change)
Before 1990, the UK had a poor inflation record compared with the other main
industrialised countries. However, since the mid -1990s prices in the UK have
been much more stable.
6.1
1990 recession
The economy went into recession between 1990 and 1992 and inflation fell
steadily as the crisis in consumer and business confidence reduced aggregate
demand. At this time the UK was a member of the Exchange Rate Mechanism
(ERM) and interest rates were kept high to maintain the value of the £ within
the ERM. The high interest rates also kept demand low.
6.2
1993–present day
The recovery in demand which started in 1993 was not accompanied by the
usual increase in inflation and apart from slight rises in 1995 and 1998
inflation has remained low. Reasons for this include:
(a)
pay awards have been low:
• job insecurity has produced a labour force which is more prepared to
tolerate low wage rises.
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• wage bargainers now expect inflation to be low so pay claims are low.
• the bargaining power of trade unions has b een reduced – many
workers are now casually employed or are employed on individual
contracts.
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(b)
low increase in prices of imported raw materials and energy because
global inflation has been low.
(c)
firms’ ability to raise prices has been limited by lo w inflation in other
countries and because of the intense competition from the Far East.
(d)
tight control of inflation by the government, particularly since 1997
when the control of inflation was handed over to the Bank of England.
The Bank does not need to consider the political disadvantages of raising
interest rates and it has not hesitated to raise them when it considered
inflationary pressures to be rising.
Deflation
Deflation occurs when the general price level is falling. It is tempting to thi nk
that if inflation is bad then deflation must be good. This is not so because:
• falling prices usually occur because of falling demand, which makes it
harder for businesses to profit and makes redundancies more likely.
• falling prices of shares and houses reduces people’s wealth. This creates a
‘feel bad’ factor which reduces consumer confidence and spending.
• the real value of debts increase, making it harder for borrowers to repay
them.
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Higher Grade Economics
Unit 5 Summary (Inflation)
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