Inflation. LO: To understand what is meant by inflation and analyse its causes

Transcription

1 Inflation LO: To understand what is meant by inflation and analyse its causes

2 Key Definitions Inflation: a sustained increase in the general price level leading to a fall in the purchasing power of money Demand Pull Inflation: where aggregate demand exceeds aggregate supply leading to an increase in the level of prices Cost Push Inflation: where increased costs of production result in firms increasing their prices leading to an increase in the general price level Tight Labour Market: where firms have to increase wages to attract the labour that they require

3 Measuring Inflation CPI Consumer Price Index The headline way of measuring inflation in the UK Allows easy comparison with other European countries Does not include housing costs RPI Retail Price Index Includes mortgage interest payments, council tax and some other housing costs not included in CPI

4 UK Currently Video: Rose to 3.5% CPI in March 2012 Why? Petrol prices Uncertainty Isnt what was expected Uncertainty is not good for investment Unnerves businesses who do not feel secure on returns Inflation greater than wage increases Squeeze on household budgets continues

5 Common Error Falling Inflation does not mean falling prices What do you think it does mean? What does a negative inflation figure mean? This is what we call DEFLATION Deflation is a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate falls below 0% (a negative inflation rate).

6 What was happening here in terms of prices? What was happening here in terms of prices? What was happening here in terms of prices according to the RPI?

7 Hyper Inflation: Inflation that is very high or "out of control", a condition in which prices increase rapidly as a currency loses its value Stagflation: A period of slow economic growth and high unemployment (stagnation) while prices rise (inflation)

8 Price Level Demand Pull Inflation AD 2 LRAS AD 1 TO AD 2 the labour market becomes tight, hence increased inflationary pressure AD SRAS AD 1 Real Output Causes of Demand Pull Inflation: 1. Depreciation of the exchange rate making imports more expensive and exports cheaper 2. Higher demand from Fiscal Stimulus (reduction in taxes or increase in government spending) 3. Monetary stimulus (reduction in interest rates) 4. Faster economic growth in other countries creating a boost to exports (BRIC)

9 Price Level Cost Push Inflation AD SRAS 1 Real Output SRAS Causes of Cost Push Inflation: 1. Increase in component costs e.g. copper, oil, agricultural products 2. Rising labour costs wage increases that are greater than productivity increases increase unit cost. Wage increases often occur when unemployment is low due to scarcity of labour 3. Expectations of Inflation if workers expect inflation to continue rising they demand wage increases to protect their quality of living, which is granted, create cost increases 4. Higher indirect taxes the incidence of the tax is determined by the PED 5. A fall in the exchange rate, increasing the cost of imported goods

10 Controlling Inflation 2 approaches: 1. To slow the rate of growth of AD 2. To boost the rate of growth of AS 1. Fiscal Policy Cut spending on public and merit goods Cut welfare payments Raise direct (on income and wealth) taxes BUT What will the implication be for jobs and economic growth in the short term?

11 2. Monetary Policy MPC can increase the Interest Rate to reduce consumption and investment BUT Although this can be used to dampen demand pull inflation, by increasing interest rates it creates cost push by increasing the cost of interest payments

12 3. Supply Side Policies Policies to increase productivity, competition and innovation

13 Controlling Inflation Time Based Summary Short Term Government and MPC to keep control of AD to a level consistent with productive capacity (not a positive output gap) Generally agreed than Monetary Policy is more effective than Fiscal Policy Medium Term Long Term Productivity, Competition and Innovation are key Growth of the supply side productive potential