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What is Inflation?
Inflation is a sustained increase in the general price level
This leads to a fall in the real purchasing power of money i.e. a rise in the cost of living
What are unit labour costs?
Reflect total labour costs, including social security and employers’ pension contributions, and including the costs of self-employed labour, incurred in the production of a unit of economic output.
How can deflation be good?
Results from technological processes, which initiates excess supply of goods and services
How is deflation bad?
Bad deflation is born out of falling AD for goods and services. Deflation becomes bad when consumers save their money for future uncertainties, or in the expectation that prices may lower further.
What is Cost Push Inflation?
When the costs of production for businesses increase; this can include increases in wage costs, the cost of raw materials, rents, or indirect taxes such as VAT.
Output of goods and services and employment both tend to fall; this is because a rise in costs often leads to a fall in business profits and planned investment spending.
It can bring about stagflation; slow growth and rising inflation. During the 1970s, when world oil prices rose dramatically, UK inflation rose to nearly 30%.
What is Demand Pull Inflation?
When total demand for goods and services exceeds total supply.
As the economy approaches full employment (or full capacity), labour and raw material shortages occur more frequently which then makes it more difficult for firms to expand production to meet rising demand.
Furthermore, when the total demand in the economy rises, it encourages producers to raise their prices and increase their profit margins. This causes the economy’s GPL to rise. The closer to full capacity that the economy gets, the more rapid the increase in the price level.
Usually associated with an increase in real GDP i.e. economic growth, and an increase in employment levels.
What is the monetarist explanation for Inflation?
Inflation is demand pull in nature, however increased demand is caused by increases in the money supply
“Inflation is always and everywhere a monetary phenomenon” - Milton Friedman
What is the Quantity Theory of Money?
When an economy’s money supply is increased more quickly than the economy’s growth rate, we can expect there to be inflation. “Too much money chasing too few goods”.
Some famous periods of hyperinflation (e.g. Germany in the 1920s and Zimbabwe in 2008) are often attributed to increases in the money supply.
What is the Fisher Equation?
MV = PT MV = PY
What impact does inflation have on international competitiveness?
If the UK has higher inflation than the rest of the world, it will lose price competitiveness in international markets.
This assumes a fixed exchange rate. If the exchange rate depreciates, this may help to restore some of the lost competitiveness.
Inflation Impact: Lenders vs Debtors
Inflation effectively erodes the value of money over time.
This is good for debtors and bad for lenders if the real interest rate is negative.
Real interest rate = Nominal Interest Rates - Inflation Rates
What is the Wage Price Spiral?
Price rises can lead to higher wage demands as workers try to maintain their real standard of living.
Higher wages over and above any gains in labour productivity causes an increase in unit labour costs . (i.e. Bad for UK business.)
To maintain their profit margins they increase prices. The process could start all over again and inflation may get out of control.
Inflation Impact: Unemployed vs Employed
Higher inflation causes an upward spike in inflationary expectations that are then incorporated into wage bargaining (unions vs employers). It can take some time for these expectations to be controlled. Consumers and businesses on fixed incomes will lose out
Many pensioners are on fixed pensions so inflation reduces the real value of their income year on year. The state pension is normally updated each year in line with average inflation so that the real value of the pension is not reduced. The same goes for people living on social security (benefits).
Inflation Impact: Non-unionised workers vs Unionised workers
Workers in a union, especially a strong one, are more likely to gain from wage bargaining with their employer as a result of inflation.
They are also more likely to have a pension plan which adjusts better for inflation that their employers will stick to.
Inflation Impact: Tax Payers - Fiscal Drag
Middle Income taxpayers are now paying some of their income at the top rate because income tax allowances have not risen as fast as wages over the last decade.
Freezing tax thresholds increases people's taxable income without nominal tax rates actually increasing. This results in additional revenue to the Government. More taxpayers are 'dragged' into paying tax, or into paying tax at a higher rate.
Inflation Impact: Investment:
Causes a disruption of business planning – uncertainty about the future makes planning difficult and this may have an adverse effect on the level of planned capital investment.
Budgeting becomes a problem as firms become unsure about what will happen to their costs.
If inflation is high and volatile, firms may demand a higher nominal rate of return on planned investment projects before they will go ahead with the capital spending.
These hurdle rates may cause projects to be cancelled or postponed until economic conditions improve.
A low rate of new capital investment clearly damages long-run economic growth and productivity.
CPI usually leads to a slower growth of profits which can then feed through into business investment decisions.
How can Fiscal Policy deal with Inflation?
Contractionary fiscal policy could include less spending on state-provided services, reduced welfare payments or raising direct taxes to cut household disposable income. This would cause AD to shift left and help reduce DPI
How can Monetary Policy deal with Inflation?
A tightening of monetary policy via higher interest rates or tougher controls on commercial bank lending
Higher interest rates causing the exchange rate to appreciate bringing cheaper imported goods and services which leads to a reduction in the consumer price index
What are shoe leather costs?
When prices are unstable, there will be an increase in search times to discover more about prices.
Inflation increases the opportunity cost of holding money, so people make more visits to their banks and building societies (wearing out their shoe leather!)
How can Inflation benefit Business Growth and Higher Stock Values?
Controlled growth of inflation can become part of business growth, because savings are often invested because of the net loss if they are kept in a bank.
Stocks bought at an earlier value, could rise in price and sold off at a higher price bringing higher profitability.
What are demand side causes leading to deflation?
Deep fall in total demand in an economy, causing a persistent recession / depression
This is usually characterised by a high level of spare capacity
What are supply side causes leading to deflation?
Improved productivity of labour and capital
Technological advances in the production process that lowers unit costs
Falling wage rates
High, strong exchange rate causing import prices to fall, causing SRAS to shift outwards.
What are the economic effects of deflation?
Holding back on spending - Consumers may postpone demand if they expect prices to fall further in the future. This lowers AD and can cause a deeper fall in real GDP i.e. prolonged recession
Debts increase - The real value of debt rises which can be a big drag on consumer confidence and spending
The real cost of borrowing increases - Real interest rates will rise if nominal rates of interest do not fall in line with prices.
Lower profit margins - Lower prices reduce revenues & profits for businesses - this can lead to higher unemployment as firms reduce costs by shedding labour.
Income distribution - Leads to a redistribution of income from debtors to creditors – but debtors may then default on loans
Deflation can make exporters more competitive eventually – but this often comes at a cost i.e. a higher rate of unemployment in the short term
What is the potential conflict between economic growth and inflation?
The risk of accelerating inflation is greatest when aggregate supply is inelastic i.e. when the economy has low spare capacity
If an economy suffers high inflation and a slowdown in economic growth – this is called stagflation
The conflict between can be resolved by having effective supply-side policies
What is the Short-Run Phillips Curve?
Used to illustrate the possible trade off between unemployment and inflation. Inversely proportional relationship
The theory behind this suggested that falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemployment to rise.
If a government wanted to reduce the unemployment rate, it could increase AD, but although this might temporarily increase employment, it could have inflationary implications in the labour and product markets.
How can the Phillips Curve be Elastic?
When the unemployment rate is high, wage pressures in the labour market are likely to be low – workers have little relative bargaining power because they can be easily replaced by someone willing to work at a lower wage
There is plenty of spare capacity in the labour market such as many unfilled jobs vacancies
Fears over job security might also lead to workers being unwilling to bid for higher wages
How can the Phillips Curve be Inelastic?
As unemployment falls, labour shortages may cause an increase in wage inflation and higher unit labour costs
When an economy is booming, so does the derived demand for and prices of components and raw materials – leading to higher costs
Rising demand and falling unemployment can lead to suppliers raising prices to increase their profit margins
Workers have relatively more bargaining power, because they are a scarce resource and in demand by firms
What are the possible inflationary effects in the labour and product markets from an increase in national income, output and employment?
The labour market - As unemployment falls, labour shortages may occur where skilled labour is in short supply. This puts pressure on wages and prices to rise
Other factor markets - Cost-push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass
Product markets - Rising demand allows suppliers to lift prices to increase their profit margins. The risk of rising prices is greatest when demand is out-stripping supply-capacity
What is NAIRU? - Inflation
The rate of unemployment when the rate of wage inflation is stable.
It assumes that there is imperfect competition in the labour market where workers have bargaining power perhaps as a member of a trade union. Set against the influence of trade unions, some employers have monopsony power when they purchase labour inputs.
If the actual unemployment falls below the NAIRU, theory suggests that the balance of power shifts to the employees. The consequence can be that the economy experiences acceleration in pay settlements. Ceteris paribus, an increase in wage inflation will cause a rise in CPI pressure,
What is Friedman’s Expectation-Augmented Phillips Curve?
He proposed that in the long run, the curve should be drawn as vertical and as a result there was no trade off.
Each SRPC was drawn on the assumption of a given expected rate of inflation. So if there were an increase in inflation caused by a monetary expansion and this had the effect of driving inflationary expectations higher this would cause an upward shift in the SRPC.
The monetarist view is that attempts to boost AD to achieve faster growth and lower unemployment have only a temporary effect on jobs
Friedman argued that a government could not permanently drive unemployment down below the NAIRU – the result would be higher inflation which in turn would cost jobs and hit growth but with inflation expectations increased along the way.
Why might there have been an improved trade-off between unemployment and inflation?
Improved labour mobility and incentives
Impact of skilled migration into the labour market
Reduced worker bargaining power / rise of monopsony employers
Effects of globalisation / technological change on consumer prices
Some economists believe that frictional and structural unemployment has fallen in recent years. This might have been caused by the UK labour market becoming more efficient at matching unemployed workers to infilled vacancies.
Digital platforms that provide better information to people on job opportunities could be a factor here. A decade or more of increased spending on vocational training and education reforms might have led to a lower rate of structural unemployment.
What is the Long Run Phillips Curve?
Neo-classical economists believe that in the long run, output always returns to a long run equilibrium path
They also argue that an economy will tend to revert to a level of output where unemployment returns to the natural rate of unemployment
The Long Run Phillips Curve is drawn as vertical i.e. it is independent of the level of short run demand/output and the general price level.
What effect does a fall in NAIRU have on the LRPC?
Successful supply-side policies that help to:
Improve the occupational mobility of labour force
Attract more people into an active search for work
Reduce the problem of occupational immobility
Lift labour productivity
These policies can lead to a fall in the natural rate of unemployment (frictional + structural unemployment) and this causes the LRPC to shift to the left.
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