Causes & Effects of Inflation

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Causes & Effects of Inflation

  1. 1. 01/11/2010 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 1
  2. 2. 01/11/2010 UK Consumer Price Inflation The consumerchange in the Consumer Price Index Annual % price index (CPI) 6.0 6.0 5.0 5.0 4.0 4.0 3.0 3.0Percent CPI Inflation target = 2% 2.0 2.0 1.0 1.0 0.0 0.0 -1.0 -1.0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: UK Statistics Commission Mapping the main causes of inflation in the UK Exchange rate Basic Bonuses + Import / Profit margins Pay overtime Prices + Global Economic Commodity Cycle Unit labour Prices Earnings costs + = Rate of + inflation Productivity Taxes + Economic Secular Fiscal Policy Cycle Influences Profit Margins (e.g. ICT impact, quality of education) Economic Cycle 2
  3. 3. 01/11/2010 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 –DDemand-pull i fl ti associated with b d ll inflation i t d ith 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 3
  4. 4. 01/11/2010 Illustrating demand-pull inflationGeneral Price LRAS Level SRAS1 P2 P1 AD2 AD1 Y1 Yfc Y2 National Income SRAS responds to excess aggregate demand General Price LRAS SRAS2 Level SRAS1 P3 P2 P1 AD2 AD1 Y1 Yfc Y2 National Income 4
  5. 5. 01/11/2010 Demand-pull inflation using a non- linear AS curve General Price LRAS Level P3 P2 P1 AD3 SRAS AD2 AD1 Y1 Y2 Yfc Real National Income The Output Gap and Consumer Price Inflation Inflation and output gapCPI inflation - annual % change in prices Output Gap = Actual GDP - Potential GDP. for the UK 10.0 10.0 8.0 8.0 6.0 6.0 4.0 4.0 CPI Inflation 2.0 2.0Per cent 0.0 0.0 Output gap -2.0 -2.0 -4.0 -4.0 -6.0 -6.0 -8.0 -8.0 90 92 94 96 98 00 02 04 06 08 10 Source: UK Statistics Commission and OECD World Economic Outlook 5
  6. 6. 01/11/2010 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 LRAS SRAS2General Price SRAS1 Level P2 P1 AD1 Y2 Y1 Yfc National Income 6
  7. 7. 01/11/2010 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 UK Inflation and Crude Oil Prices Oil prices the Consumer Price Index and monthly average for Brent Crude Annual % change in and CPI inflation 150 150 SD/Barrel 100 Crude Oil Price 100US 50 50 0 0 6.0 6.0 5.0 5.0 4.0 4.0 Percent Consumer Price Inflation 3.0 3.0 P 2.0 2.0 1.0 1.0 0.0 0.0 06 07 08 09 10 Source: UK Statistics Commission and IPE 7
  8. 8. 01/11/2010 Average Earnings Consumer Prices - A Link? Wage Growth and and Consumer Annual % change in earnings and consumer prices 6 Prices in the UK 6 5 Average Earnings 5 4 4Percent 3 3 2 Consumer price inflation 2 1 1 0 0 00 01 02 03 04 05 06 07 08 09 10 Source: Reuters EcoWin Import prices can have a direct Statistics Index of UK Import Prices Index 2003=100, source: Monthly Digest of Economic 200 effect on the rate of inflation 200 175 175 150 150 125 125 Finished Manufactured GoodsIndex 100 100 Total Import Price Index 75 75 Import Prices for Fuels 50 50 25 25 01 02 03 04 05 06 07 08 09 10 Imports of Goods exc oil Imports of finished manufactures Imports of Fuels Source: Reuters EcoWin 8
  9. 9. 01/11/2010 How does the exchange rateRate for the UK Inflation and the Exchange affect Exchange rate index (top pane) and inflation (lower pane) 110 inflationary pressures? 110 Sterling Exchange Rate Index 100 100Index 90 90I 80 80 70 70 6.0 6.0 Consumer Price Inflation 5.0 5.0 4.0 4.0 Percent 3.0 3.0 P 2.0 2.0 1.0 1.0 0.0 0.0 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Source: Reuters EcoWin Consequences of inflation 9
  10. 10. 01/11/2010 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 inflation i fl ti on growth i l th is 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 and people lose confidence in money as the value y 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 in p p y poor bargaining p g g positions lose out and suffer a reduction in their real living standards and relative income level (i.e. to other groups) 10
  11. 11. 01/11/2010 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 g global competitiveness and a worsening of the p g balance of payments position • A possible cause of higher unemployment • Rising inflation is associated with higher policy interest rates - this reduces trend growth Economic Growth and Inflation UKUK Real GDP Growth and Consumer Price Inflation. annual % change Economic Growth and Inflation 10.0 10.0 7.5 7.5 5.0 Real GDP growth 5.0 2.5 2.5Percent 0.0 Consumer price inflation 0.0 -2.5 -2.5 -5.0 -5.0 -7.5 -7.5 90 92 94 96 98 00 02 04 06 08 10 Source: UK Statistics Agency 11
  12. 12. 01/11/2010 Anticipated inflation• When people are able to make accurate predictions of inflation they can take inflation, 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, businesses (people 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 12
  13. 13. 01/11/2010 Inflation Expectations Inflation expectations Bank of England/NOP, how do you expect prices to change over the next 12 months? 6.0 6.0 5.0 5.0 4.0 4.0Percent 3.0 3.0 2.0 2.0 1.0 1.0 0.0 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 13
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