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Causes & Effects of Inflation

A2 Economics, November 2010

Causes of inflation
Inflation is a sustained increase in the general level of prices There are many possible causes of price inflation in an economy for example
1. Demand and supply-side causes 2. Inflation from internal and external sources 3. Inflationary effects of government / regulatory intervention in the economy

Average rates of inflation vary widely across the world across countries at different stages of development

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The consumer price index (CPI) Annual % change in the Consumer Price Index
6.0 5.0 4.0
Percent

UK Consumer Price Inflation

6.0 5.0 4.0 3.0
CPI Inflation target = 2%

3.0 2.0 1.0 0.0 -1.0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

2.0 1.0 0.0 -1.0

Source: UK Statistics Commission

Mapping the main causes of inflation in the UK

Basic Pay Bonuses + overtime Import Prices + Commodity Prices Unit labour + costs + Exchange rate / Profit margins Global Economic Cycle =

Earnings

Rate of inflation

Productivity Taxes + Economic Cycle Secular Influences (e.g. ICT impact, quality of education) Fiscal Policy Profit Margins

Economic Cycle

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Demand-pull inflation
Demand pull inflation
When there is excess demand for goods and services Positive output gap (where actual GDP > Potential GDP) Businesses respond by raising prices to increase profit margins Demand-pull D d ll i inflation fl ti associated i t d with ith b boom phase of the cycle (SRAS becomes inelastic) Root causes of demand pull inflation are usually monetary in origin (excessive lending / growth of the money supply monetarist causes)

Main causes of demand pull inflation

A large depreciation of the exchange rate A reduction in direct or indirect taxation 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 economic growth in other countries providing a boost to UK exports overseas

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Illustrating demand-pull inflation

General Price Level LRAS SRAS1 P2 P1

AD1

AD2

Y1

Yfc Y2

National Income

SRAS responds to excess aggregate demand

General Price Level P3 P2 P1 LRAS SRAS2 SRAS1

AD1

AD2

Y1

Yfc Y2

National Income

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Demand-pull inflation using a nonlinear AS curve

General Price Level P3 LRAS

P2

P1

AD3 SRAS AD1 AD2

Y1

Y2 Yfc

Real National Income

Inflation gap for the UK Output Gap and = Actual output GDP - Potential GDP. CPI inflation - annual % change in prices
10.0 8.0 6.0 4.0
Per cent

The Output Gap and Consumer Price Inflation

10.0 8.0 6.0 4.0
CPI Inflation

2.0 0.0 -2.0 -4.0 -6.0 -8.0 90 92 94 96 98 00

Output gap

2.0 0.0 -2.0 -4.0 -6.0 -8.0

02

04

06

08

10

Source: UK Statistics Commission and OECD World Economic Outlook

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Cost Push Inflation

Causes:
External shocks ( (i.e. commodity y price fluctuations) ) A depreciation in the exchange rate (higher import costs) Acceleration in wages / unit labour costs in the labour market

Leads to an inward shift in SRAS curve Firms raise prices to protect their profit margins better able to do this when demand is price inelastic Wages often follow prices - a second-round effects of an increase in the cost of living Rise in actual inflation can lead to an increase in inflationary expectations

Illustrating cost-push inflation

LRAS
General Price Level

SRAS2 SRAS1

P2 P1

AD1

Y2

Y1

Yfc

National Income

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Illustrating cost-push inflation with a non-linear SRAS

LRAS General Price Level

P2 P1

SRAS2 SRAS1 AD1 AD2 Y3 Y2 Y1 Yfc Real National Income

Oil and CPI inflation Annualprices % change in the Consumer Price Index and monthly average for Brent Crude
150
US SD/Barrel

UK Inflation and Crude Oil Prices

150
Crude Oil Price

100 50 0 6.0 5.0 4.0 3.0 2.0 1.0 0.0

100 50 0 6.0 5.0 4.0 3.0 2.0 1.0 0.0

Percent P

Consumer Price Inflation

06

07

08

09

10

Source: UK Statistics Commission and IPE

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6 5 4
Percent

Wage Growth and Consumer Prices - A Link? Average Earnings and Consumer Annual % change in earnings and consumer prices Prices in the UK
Average Earnings

6 5 4 3

3 2 1 0 00 01 02 03 04 05 06 07 08 09 10
Consumer price inflation

2 1 0
Source: Reuters EcoWin

200

Index of have UK Import Prices Import prices can a direct Index 2003=100, source: Monthly Digest of Economic Statistics effect on the rate of inflation

200

175

175

150

150

125
Index

Finished Manufactured Goods

125

100

100

Total Import Price Index

75
75

Import Prices for Fuels

50
50

25 01 02 03 04 05 06 07 08 09 10

25

Imports of Goods exc oil Imports of Fuels

Imports of finished manufactures

Source: Reuters EcoWin

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Inflation and the Exchange for the UK How does the exchange rateRate affect Exchange rate index (top pane) and inflation (lower pane) inflationary pressures? 110
Sterling Exchange Rate Index

110 100 90 80 70

100
Index I

90 80 70 6.0 5.0 4.0 3.0 2.0 1.0 0.0

Consumer Price Inflation

6.0 5.0 4.0 3.0 2.0 1.0 0.0

Source: Reuters EcoWin

Percent P

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Consequences of inflation

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The costs of inflation

Taken together, the verdict of economics, history and common sense is that inflation and deflation are costly. It is clear that high inflation in extreme cases hyperinflation can lead to a breakdown of the economy. There is now a considerable body of empirical evidence that inflation and output growth are negatively correlated in high-inflation countries. For inflation rates in single figures, the impact of i fl ti on growth inflation th i is l less clear. l Mervyn King adapted from a speech entitled The Inflation Target Ten Years On given in 2002

Costs and Consequences of Inflation (1)

Money loses its value or real purchasing power y as the value and people lose confidence in money 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. Employees p y in p poor bargaining g gp positions lose out and suffer a reduction in their real living standards and relative income level (i.e. to other groups)

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Costs and Consequences of Inflation (2)

Inflation can favour borrowers at the expense of savers because inflation erodes the real value of existing debts- if real interest rates are negative Inflation can disrupt business planning and lead to lower capital investment Exporters may suffer if prices in the UK rise higher than those abroad causing a deterioration in global competitiveness g p and a worsening g of the balance of payments position A possible cause of higher unemployment Rising inflation is associated with higher policy interest rates - this reduces trend growth

UKUK Economic Growth and Inflation Real GDP Growth and Consumer Price Inflation. annual % change
10.0 7.5 5.0
Percent

Economic Growth and Inflation

10.0 7.5
Real GDP growth

5.0 2.5

2.5 0.0 -2.5 -5.0 -7.5 90

Consumer price inflation

0.0 -2.5 -5.0 -7.5

92

94

96

98

00

02

04

06

08

10

Source: UK Statistics Agency

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Anticipated inflation
When people are able to make accurate predictions of inflation inflation, they can take steps to protect themselves from its effects For example, trade unions may exercise their collective bargaining power to negotiate with employers for increases in money wages so as to protect the real wages of union members

Unanticipated inflation
Unanticipated inflation occurs when economic agents (people, (people businesses and governments) make errors in their inflation forecasts Actual inflation may end up well below, or significantly above expectations causing losses in real incomes and a redistribution of income and wealth from one group in society to another

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Bank of England/NOP, how do you expect prices to change over the next 12 months?

Inflation expectations

Inflation Expectations
6.0 5.0 4.0 3.0 2.0 1.0 0.0

6.0 5.0 4.0

Percent

3.0 2.0 1.0 0.0 04 05 06 07 08 09 10

How do you expect prices to change over the next 12 months? How has prices changed over the past 12 months?

Source: Bank of England

Some Inflation Web Resources

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