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Causes & Effects of inflation (Nov 10)
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Transcript of Causes & Effects of inflation (Nov 10)
01/11/2010
1
Causes & Effects ofEffects 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 example1. 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
UK Consumer Price Inflation
5.0
6.0
5.0
6.0
1.0
2.0
3.0
4.0
Pe
rce
nt
1.0
2.0
3.0
4.0
CPI Inflation target = 2%
Source: UK Statistics Commission
97 98 99 00 01 02 03 04 05 06 07 08 09 10 11-1.0
0.0
-1.0
0.0
Mapping the main causes of inflation in the UK
Import Prices
Basic Pay
Bonuses + overtime
Exchange rate / Profit margins
Earnings
Productivity
Unit labour costs
Commodity Prices
Taxes
Rate of inflation
Global Economic Cycle
+ =+
+
Taxes
Profit Margins
Secular Influences(e.g. ICT impact, quality of education)
Economic Cycle
Economic Cycle
Fiscal Policy+
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Demand-pull inflation
• Demand – pull inflation – When there is excess demand for goods and– 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
D d ll i fl ti i t d ith b– Demand-pull inflation associated with 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 taxationA 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• Faster economic growth in other countries –providing a boost to UK exports overseas
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Illustrating demand-pull inflationGeneral
Price Level
SRAS1
LRAS
P1
P2
National Income
AD1
Y1 Yfc Y2
AD2
SRAS responds to excess aggregate demand
General Price Level
SRAS1
LRAS SRAS2
P3
P1
P2
P3
National Income
AD1
Y1 Yfc Y2
AD2
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Demand-pull inflation using a non-linear AS curve
General Price Level
LRAS
P1
P2
P3
Real National Income
AD1
SRAS
Y1 Yfc
AD2
Y2
AD3
Inflation and output gap for the UKOutput Gap = Actual GDP - Potential GDP. CPI inflation - annual % change in prices
The Output Gap and Consumer Price Inflation
6.0
8.0
10.0
6.0
8.0
10.0
-4.0
-2.0
0.0
2.0
4.0
Pe
r ce
nt
-4.0
-2.0
0.0
2.0
4.0
CPI Inflation
Output gap
Source: UK Statistics Commission and OECD World Economic Outlook
90 92 94 96 98 00 02 04 06 08 10-8.0
-6.0
-8.0
-6.0
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Cost Push Inflation
• Causes:– External shocks (i.e. commodity price fluctuations)( y )
– 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
SRAS1
LRASSRAS2
General Price Level
P1
P2
National Income
AD1
Y1 YfcY2
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Illustrating cost-push inflation – with a non-linear SRAS
General Price Level
LRAS
P1
P2
Real National Income
AD1
SRAS1
Y1 Yfc
SRAS2
Y2
AD2
Y3
Oil prices and CPI inflationAnnual % change in the Consumer Price Index and monthly average for Brent Crude
UK Inflation and Crude Oil Prices
100
150
SD
/Ba
rre
l
100
150
Crude Oil Price
3.0
4.0
5.0
6.0
Pe
rce
nt
3.0
4.0
5.0
6.0
Consumer Price Inflation
0
50US
0
50
Source: UK Statistics Commission and IPE
06 07 08 09 100.0
1.0
2.0
P
0.0
1.0
2.0
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Average Earnings and Consumer Prices in the UKAnnual % change in earnings and consumer prices
Wage Growth and Consumer Prices - A Link?
5
6
5
6
Average Earnings
2
3
4
Pe
rce
nt
2
3
4
Consumer price inflation
Source: Reuters EcoWin
00 01 02 03 04 05 06 07 08 09 100
1
0
1
Import prices can have a direct effect on the rate of inflation
Index 2003=100, source: Monthly Digest of Economic Statistics
Index of UK Import Prices
150
175
200
150
175
200
75
100
125
150
Ind
ex
50
75
100
125
150
Total Import Price Index
Import Prices for Fuels
Finished Manufactured Goods
Imports of Goods exc oilImports of Fuels
Imports of finished manufactures
Source: Reuters EcoWin
01 02 03 04 05 06 07 08 09 10
25
50
25
50
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How does the exchange rate affect inflationary pressures?
Exchange rate index (top pane) and inflation (lower pane)
Inflation and the Exchange Rate for the UK
90
100
110
Ind
ex
90
100
110Sterling Exchange Rate Index
3.0
4.0
5.0
6.0
Pe
rce
nt
3.0
4.0
5.0
6.0Consumer Price Inflation
70
80
I
70
80
Source: Reuters EcoWin
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 100.0
1.0
2.0
P
0.0
1.0
2.0
ConsequencesConsequences 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 th i l l ’inflation on growth is less clear.’
• 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 and people lose confidence in money as the value yof 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 in poor bargaining positions lose out p y p g g pand 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 and a worsening of the g p gbalance of payments position
• A possible cause of higher unemployment
• Rising inflation is associated with higher policy interest rates - this reduces trend growth
UK Economic Growth and InflationUK Real GDP Growth and Consumer Price Inflation. annual % change
Economic Growth and Inflation
7.5
10.0
7.5
10.0
-2.5
0.0
2.5
5.0
Pe
rce
nt
-2.5
0.0
2.5
5.0
Consumer price inflation
Real GDP growth
Source: UK Statistics Agency
90 92 94 96 98 00 02 04 06 08 10-7.5
-5.0
-7.5
-5.0
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Anticipated inflation
• When people are able to make accurate predictions of inflation they can takepredictions of 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 innegotiate 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 businesseseconomic agents (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 alosses in real incomes and a redistribution of income and wealth from one group in society to another
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Inflation expectationsBank of England/NOP, how do you expect prices to change over the next 12 months?
Inflation Expectations
5.0
6.0
5.0
6.0
1.0
2.0
3.0
4.0
Pe
rce
nt
1.0
2.0
3.0
4.0
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
04 05 06 07 08 09 100.00.0
Some Inflation Web Resources
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