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Explain the causes of inflation.

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Explain the Causes of Inflation Inflation is defined as a sustained general rise in prices. The opposite of inflation - Deflation - is a term which can have two meanings. Strictly speaking it is defined as a fall in the price level. However it can also be used to describe a slowdown in the rate of growth in the economy. Inflation is measured using either The Retail Price Index (RPI), the Retail Price Index excluding interest payments and indirect taxes (RPIY) or the Retail Price Index excluding mortgages (RPIX). The causes of inflation are down to four main reasons; demand-pull, cost-push, wage-price spirals and money supply inflation. Keynesians have traditionally argued that inflation occurs because of changes in real variables in the economy. One important Keynesian theory is that inflation is caused by excess demand in the economy; known as demand-pull inflation. It occurs when total demand for goods and services exceeds total supply, or in other words when the money supply grows faster than the ability of the economy to supply goods and services. When demand exceeds supply, firms are liable to increase price (as all firms wish to maximise profit), this has no effect on the demand they actually sell as there are excess numbers of people who wish to buy the product. ...read more.


However this had a bad effect in the short run in 1988, as mortgage repayment, resulting in a higher Retail Price Index. This increase of inflation then caused wage price spiralling, and inflation grew higher then ever. In order to overcome these high inflation rates, monetary policies were used. For a brief period, the government turned to the exchange rate as a means to control inflation and in 1990, the UK entered the European Exchange Rate Mechanism (ERM). Monetary policy had to be set to ensure that the pound did not strengthen or weaken by more than a certain amount against other currencies in the system. Unfortunately differences in economic conditions across Europe forced England out and they were forced to adopt a new idea. In 1992, the public's inflationary expectations changed and the rate of inflation had started to decrease more than previous levels. Instead of targeting something like the exchange rate as a means of controlling inflation, a rate for inflation itself was targeted. Interest rates were set to ensure demand in the economy was kept at a level consistent with a certain level of inflation over time. ...read more.


In addition to this, a Parliamentary Committee reviewing the performance of the MPC concluded that its quick action in the second half of 1998 helped the economy avoid a hard landing; this would suggest that the MPC has avoided high inflation and at the same time allowed the economy to run relatively quickly. However as inflation is low and stable, people's expectations of inflation have decreased too, therefore presenting the possibility of instability in the future. Also shown by the graph are the small disturbances within the 1.5% to 3.5% band. These are perhaps possibilities of small economic shocks possible caused by exogenous or endogenous goods (ones from outside the economy and inside the economy respectively). A good example of an exogenous shock is oil. It is clear that England is quite dependant on other countries for oil and so fluctuations in price/changes in quantity supplied has a strong effect on the UK economy. As prices rose in 2000, there was an inward shift in the AS curve causing upward price pressure. Overall Inflation targeting appears to have provided a successful base from which to use monetary policies. However, indicators of long-term inflation expectations still seem to reveal doubts about whether current low inflation will continue into the future. ?? ?? ?? ?? Tom King 6Y2 Page 1 ...read more.

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