- All labour is equally efficient
- All labour is completely mobile both in the occupational and geographic sense
- That all capital is mobile, i.e. it can turn from the provision of one product in one part of the country to making something else in another part very quickly
This is why this is seen as an unrealistic theory, the more realistic Keynesian theory uses the same principles but not to such a strict structure. It is known as Bottleneck or Structural Rigidity Inflation.
This is more realistic as it shows that the closer an economy gets to full levels of employment more shortages start to appear in areas such as raw materials, trained and efficient labour and the production of the finished product. Companies will also encounter the problems of having to deal with labour that is unprepared to move houses or do not have the sufficient skills to do the job that is needed. This along with boosts to aggregate demand will cause inflation.
All of the theories of the causes of inflation that have been outlined so far are for demand-pull inflation. It is also possible that either expectation led inflation or cost-push inflation could have caused the inflation. Expectation based inflation is where the expectation that there will be inflation causes inflation to occur. This can be explained through an example; if employees expect there is going to be 10% inflation over the next year they are going to demand at least a 10% wage increase, employers give in to this and pass on the 10% in the form of a 10% price increase. This will result in 10% inflation regardless of the prevailing economic conditions. The argument against this is that this can not be the cause of inflation only a way of persisting it. If inflation has been 3% in the past then it is very unlikely that the employees will expect 10% inflation, it will only be if there have been these levels of inflation in the past. This is why some economist argue that this can not be an initiating cause to the inflation.
Cost-push inflation is another Keynesian version of inflation where it is shifts in aggregate supply, not aggregate demand, which cause the inflation.
Many different circumstances can lead to cost push inflation, the most common of these used to be wages being driven up excessive amounts by aggressive and powerful trade unions, this has not been such an issue recently due to the Thatcherite reforms in the 1980’s. The cost of essential raw materials, particularly imported ones, cause cost-push inflation such as what happened in the 1970’s when the price of oil rose dramatically. An increase in food prices caused by a bad harvest either in the UK or in the countries where we import most of our food. A falling exchange rate will have the same effect as other countries raising the cost of their goods, they will become more expensive. This is particularly important in a country like the UK because it relies so heavily in imports of raw materials and foods. An increase in VAT will cause a once and for all rise in prices but this can lead to a wages spiral when they go up far too far. One of the main problems with this type of inflation is that it can lead to stagflation, this is where both prices and unemployment are rising at the same time and it can cause huge problems for an economy.
UK INFLATION OVER THE LAST PERIOD
Inflation measures how the cost of living changes through time. Goods that you could buy for £1 today might cost £2 at some point in the future. In the UK, cost of living is recorded in the form of the UK Retail Price Index (UK RPI). The level of this index is simply the price of a standardised basket of the most common consumer goods. The UK RPI is recalculated at monthly intervals. The following chart shows us how this measure of the cost of living has changed over the last century - notice that the series is presented on a proportional scale. The UK RPI shown in this chart has been re-based so that its value in 1900 is 1. The chart shows that the cost of living in the UK has increased approximately 54 times since 1900. Conversely, we could think about this, the other way round, in terms of the buying power of money: over the last century, the buying power of £1 has fallen to less than 2p.
Inflation over the last century: UK rpi 1900 - 2000 (proportional scales)
The annual rate of growth in the cost of living, as measured by the UK RPI, is called the rate of inflation, or simply inflation.
Inflation measures how much, in proportional terms, the UKRPI changes from one year to the next. It is usually expressed as an annual percentage increase. As an example, between 31 Dec 1969 and 31 Dec 1970, the UK RPI increased from 5.8 to 6.2. This change represents an increase of 7.9% during 1970. We would say that in 1970 inflation was 7.9%. If we plot this annual inflation rate, rather than the level of UK RPI, we get a rather different looking picture. Unlike UK RPI, inflation represents a proportional change, and is plotted on an ordinary linear scale.
UK inflation rate 1900-2000 (linear scale)
Although the general trend is for the cost of living to rise, during the 1920's and 1930's the cost of living actually decreased. A fall in the cost of living is referred to as deflation and corresponds to negative values for inflation (see the chart above). Although periods of deflation are rare, they do happen, and we cannot predict when. Although it is unlikely, it is quite possible that may be experienced deflation in the UK at some point in the next decade or two. Equally, although the current rate of inflation is fairly stable at between 2% and 3%, it is quite possible that inflation may increase substantially in the future.
LOWER PETROL PRICE
Ironically, the main reason for the decrease was a fall in the cost of petrol, which fell compared to the sharp increases that occurred one year ago, when the first effects of the oil price rise were beginning to be felt.
The National Statistics office said that petrol prices were likely to increase again in September. But downward pressure on prices also came from seasonal foods, although clothing and footwear prices recovered after falling in the summer sales.
The measure of inflation used by other European countries, the harmonised index of prices, which excludes taxes and housing costs, also fell to a record low of 0.6%, the lowest in the EU. The underlying rate of inflation has now been below its target for seventeen months.
RATES ON HOLD
The low rate of inflation has led the Bank of England's monetary policy committee to keep interest rates unchanged for the last seven months at 4.0%. One of the factors that has helped keep inflation in check has been the high pound, which has lowered the price of imports - although it has also hurt manufacturing exports.
Some economists warned that the Bank could still raise interest rates later in the year.
"I think it provides a justification for continuing to hold interest rates because there is that margin of safety between actual and targeted inflation. But we still think the MPC will raise interest rates one more time before the end of this year," said Michael Taylor of Merrill Lynch.
One reason may be the further pressure that could be put on prices by the falling pound.
In the longer term, the pound's weakness against the dollar could increase inflation, as imported goods from the United States will become more expensive.
However, as long as the Euro continues to be weak, the effect on inflation is likely to be limited, as the UK imports more from the EU than anywhere else.
WHAT IS DEFLATION AND WOULD IT BE A PROBLEM
The subsequent decade has been a period of low inflation almost everywhere. Most recently, with a global business cycle downturn, inflation globally has declined further, and is currently low to very low in most places. So it is natural to ask whether, after a generation worrying about inflation, we might be faced with deflation. Certainly the word 'deflation' is used with much greater frequency than it has been for a long time. Its use usually conjures up some vague notion of the Great Depression, which was the last time a widespread deflation occurred.
Deflation is a generalized and persistent decline in most, if not all, prices for goods and services. More likely than not this, if it occurred, would be accompanied by declines in prices for many real assets and pressure for, even if not the actuality of declines in wage and salary incomes.
A situation where we observe declines in the prices of some products does not qualify as deflation in this sense. It is nearly always the case that prices for some things are falling, while prices for other things are rising. A simple but useful working definition of deflation, then, is when the prices of enough goods and services decline to cause aggregate price indices like the CPI to record a fall. Deflation of that general nature was once a not-uncommon event. For example, in the 19th century, it was normal to think of a relatively stable average price level over fairly long periods, but with noticeable fluctuations around the mean over periods of some years – with periods of inflation being followed by periods of deflation. Deflation need not be harmful. In cases where exceptionally strong productivity growth accompanies very strong demand growth, the price level can fall even as beating deflation can only be achieved by restoring the Japanese economy to a sustained recovery path. To this end, revitalising private demand through structural reforms such as tax system reform is indispensable.
Although Japan successfully navigated its way through the fiscal year without a crisis, the banking system remained in sever condition. Due to the bad loans, the weak Yen currency, downward pressure from export and inventories and weak domestic demand, economic recession. The prices would go on declining.
It’s a good idea to support the stock market first. This is the practice of betting on a falling market in which a seller sells shares they do not yet own in the expectation they will be able to buy them back more cheaply later on. Driving up the stock market is intended to support the banks. Japan’s banks must write down the value of their portfolios to current market values. They have taken such action several times in recent months, with little impact. In addition, the banks should keep loaning in order to strengthen the currency liquidity, also strengthen the credit and adopt a more forward-looking approach to loan classification and provisioning. Anyway, just be more careful than before on loaning to avoid bad debts.
The most common way to deal with deflation injecting money into the market. So the more we have, the higher price will be strengthened. But many people are concerning about the currency devaluation caused by the expansion of the amount of money. Let’s see what Japanese had done. They had devalued their currency. Due to the devaluation, people from abroad are much willing to buy the “Made in Japan”. At the beginning, there may be a trade deficit. Once the change of quantity overwhelms the change of price, trade surplus will appear. So in long-term, this will be a successful strategy to take in money for the use of curbing deflation.
Structural problems lie at the heart of Japan’s economic difficulties. For more than a decade Japan has adjusted too slowly to the forces of globalisation, lagging behind in productivity growth. The country must remove the obstacles to efficiency in the domestic sectors of the economy. They also need to introduce measures to strengthen the regulatory structure improve corporate governance, increase labour market flexibility. Such policies will be important to generate new investment and employment opportunities, and raise productivity growth over the medium term. From deflation to structural reforms, none of them will be easy to implement, but bold measures are needed to return the economy to strong, sustained growth. The past decade has proved that the risk had been delayed.
• Deflation has happened many times before; arguably, a cycle of inflation followed by deflation is the normal course of economic affairs.
• Deflation is happening now, most obviously in Japan, but also in the UK in shop prices (headline inflation is due to the increase in the price of services — see the chart at the top of the next page).
• Pension funds are particularly vulnerable, as pensions cannot be decreased (because the deed and rules rarely allow it).
• Deflation is different from a simple fall in inflation because interest rates cannot go negative (because people would then keep their money under the mattress).
• Government has only limited powers through conventional monetary policy (or interest rate policy). Anyone is looking for proof of these needs to look no further than the helpless Japanese authorities.
Why might deflation be harmful? The main reason is because of fixed nominal contracting of wages, debts, etc. The real value of a dollar is higher after deflation than it was before. So if you owe a pound, your debt burden is higher. If you are owed a pound, or earning a pound, your real wealth or income is higher. Price changes of this nature, if they are unanticipated, lead to a different distribution of wealth and income than people had banked on when they made their contracts. Usually, this is disruptive to the economy (not to mention unfair). This is a problem of exactly the same nature as those, which arise with inflation, except in reverse. In time, of course, people learn that price changes are occurring, and adjust their behaviour accordingly. But adjusting incomes downward for deflation is typically harder to do than adjusting them upward for inflation. So percentage point for percentage point, deflation is arguably a bit more painful than inflation.
Harmful deflation typically occurs in parallel to developments in prices for assets and balance sheets.
This is usually in the aftermath of a boom accommodated by a big run up in debt, involving a large increase in capacity in response to very optimistic expectations about future sales and profits. When the optimistic expectations cannot be met, it is apparent that firms are over-invested and over-leveraged.
They are then under pressure to shore up their balance sheets. Asset prices fall, as firms seek to disinvest. Banks and other lenders find that the quality of their assets has deteriorated, and are tempted to reduce the flow of new credit in order to conserve their own capital. Aggregate demand in the economy declines, and prices for goods and services fall. This is the 'debt deflation' described by Irving Fisher many years ago. Depending on the size of the preceding boom, and on the policies pursued during the bust, this process can be exceedingly painful.
In the case where expectations of ongoing deflation become strongly held, moreover, it is possible that some fairly serious problems of economic management can emerge. Expectations that prices will continually fall may lead people to postpone spending, which of course amplify the deflationary pressure. The rate of deflation might, in extreme circumstances, also mean that attempts to boost growth by reducing interest rates run into the problem that the nominal interest rate cannot fall below zero, which might mean that the real interest rate is too high for the economy's needs.
One could debate in each individual case what the proximate causes of this are, and whether it is 'good' deflation or bad. China's deflation is arguably a candidate to be classified as 'good' deflation, since it seems to be associated with rapid overall growth and rising living standards. Hong Kong's deflation is partly necessitated by the peg to the strong US dollar, though of the cumulative decline of about 13 per cent in Hong Kong's CPI since mid 1998, about half is due to declining rents, which is more associated with the decline in housing values after the earlier boom there. Of course, Hong Kong has an impressive capacity to adjust to these shocks, but even so it is a painful process. There is no doubt that Japan's deflation is of the bad kind.
Not the kind of mild temporary deflation which is a short-term period of economic weakness, but the kind of deflation which might itself be a cause of further economic weakness in future. The reason we so concerned is the possibility that it may not be easy to escape from such a situation. For instance an economy in which deflation is strongly expected to continue, at a rate which exceeds the natural real interest rate in the economy – that is the equilibrium return on real capital. In that situation, because nominal interest rates cannot fall below zero, the real interest rate set by the central bank cannot go below the natural rate. Since conventional monetary policy works in an expansionary direction by lowering interest rates in the financial sector below the natural rate, it follows that conventional monetary policy is rendered incapable of applying stimulus to an economy in this situation. The real interest rate is too high, which means that policy remains too prolonging the deflationary pressure. There is a 'deflation trap', or a 'liquidity trap'.
Some have argued that this is the right diagnosis of Japan's situation. The question is: how likely is it that other countries will get into this sort of problem? It is less likely to occur in most of the other more dynamic economies of Asia. These countries must have tremendous opportunities for profitable investment in future. On that assumption, the natural interest rate is almost certainly much higher than the present or likely future rate of deflation. So while deflation or very low inflation in these countries is probably a sign of temporarily weak demand, which is something that policymakers there presumably wish to address, it still does not seem all that likely that they will find themselves in a deflation trap.
CONCLUSION
The first thing to say is that, for most countries, deflation is an outcome which is to be avoided, just like inflation is to be avoided. Stability in the general level of prices, interpreted in practice as a low but positive rate of price increase, is the appropriate goal. Forward-looking monetary policies should be seeking to maintain inflation above zero, just as actively as they look to keep it below some maximum rate. Also the thing to be avoided most strenuously is a persistent deflation which becomes embodied in expectations. It is in this situation where questions of deflation traps become relevant, particularly in countries where the natural interest rate has come down to very low levels. Policy must work at keeping price expectations from falling too far, just as hard as it worked to get expectations down from excessive levels in earlier times, by articulating goals clearly, and being seen to take action consistent with achieving those goals.
The fact that we are talking about the possibility of it at all is a remarkable change from only a few years ago. Insofar as that means that the 'great inflation' is well and truly finished, that is a good thing, provided of course that we are alert to the new sorts of risks, which can emerge.
For the average country, a short-lived experience with mild deflation would just be a sign that there is a problem of insufficient aggregate demand which ideally should have been avoided, but which, failing that, should be addressed quickly. The observed deflation would be telling us the same thing as various real activity indicators: things are weak and the economy needs encouragement to grow.
The bigger concern would be the possibility of a ‘deflation trap’ where conventional monetary policy would become largely ineffective. It seems that in most countries this is not all that likely an outcome anyway, but good policies all round should be able to lessen the probability of it further.
REFERENCES
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Amano, R, Coletti, D and Macklem, T (1998), ‘Monetary rules when economic behaviour changes’
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Athanasios Orphanides, 2001. "," 2001-62, Board of Governors of the Federal Reserve System (U.S.)
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Stephen Icon, 2000. “Economics” pp. 202-216
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William Poole, 1999. "," , pp. 3-12.
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June, 1998 “Deflation; Why It's Coming, Whether It's Good or Bad, and How It Will Affect Your Investments, Business, and Personal Affairs”