Cost push inflation can also be caused when there is an increase in import prices or indirect taxation. In macroeconomic scale, cost-push inflation is an effect of supply-side shocks. The Organization of the Petroleum Exporting Countries (OPEC) oil embargos was the famous example of supply-side shocks during the early and late 1970s. The financial consequence of the oil embargoes was a flow in the price of oil and other petroleum products. High cost of oil results the energy prices to fly high, that cause electricity prices to soar.
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Question B
Assess why inflation has been so low over the last eight years. What have been the main policies that have led to this situation?
Answer
Inflation has been so low over the last eight years because of the following reasons
Low wage inflation from the labour market
There has been a large fall in unemployment as well as wages/salaries are being increased by a self-effacing rate.
The success of monetary policy in the UK
Bank of England has succeeded following the monetary policy i.e. controlling the aggregate demand through the changes in interest rates.
Information technology effects
As Information and Communication technology has increased, hastily that lends a hand to reduce costs and is completed with #more prices that are transparent for consumers and e-trade has a vast role in taking prices down in many markets.
Increased competition
There is a huge competition in various souks and that made companies to maintain their prices, try to find to upgrade their efficiency and shrink profit margins. Due the globalization many UK firm has to face severe pressure from overseas contenders.
However, the UK financial system has controlled the inflation by preventing demand for goods and services growing too rapidly, and low inflation depends on the grouping of demand and supply-side factors.
“In the 1990s, the UK experienced a non-inflationary consistently expansionary - or "nice" - decade; a decade in which growth was a little above trend, unemployment fell steadily, and cheaper imports allowed consumers to enjoy rising living standards without the need to ask for inflationary pay claims”
The main policies followed by UK government to maintain inflation level
Following are the three main policies followed by UK government to get least value of inflation.
Fiscal Policy
Government controls the demand for goods through Fiscal policy. When the aggregate demand is too high, the government may use the fiscal policy to reduce public funds or to increases direct or indirect taxes to raise the disposable income of such families. AD is the total of planned expenditure in economy.
(AD= C+I+G+X-M)
This policy is said to be contractionary when revenue is higher than spending and to loose when expenditure is higher than the income to control inflation, it could be done by cutting spending or raising the taxes. This helps to take money out of the circular flow of revenue and expenditure
Monetary Policy
The monetary policy has to be delivered by the bank of England based on Consumer Price Index (CPI). It is the policy that helps in setting the stable prices (low inflation), in addition to that to prop up government economic growth and employment.
The target of inflation according UK bank is 2%, and this has to be announced by the chancellor of the exchequers in the annual financial statement. Neither the inflation should be less nor it more then the target value, if it is, then it is called as bad inflation.
The governor of the bank has to give a written justification to the chancellor when the inflation is increased or decreased by more then 1% of the target value that why its has been increased/decreased by such circumstances and that the bank is proposed to do in order to take the inflation level back to the target value.
Inflation rate is not constant forever; it could change by large quantity, originating redundant uncertain and volatile changes in the economy. However, the bank believes that inflationary rate should build up to high level in short-terms.
The inflation rate has to be setup by a special committee known as Monetary Policy Committee (MPC). All over there are nine members in this committee, five from the bank of England and four external members selected by the chancellor of the bank. The governor of the bank in a two-day meeting follows it and the rate of inflation is announced on the second day of the meeting.
Supply side policy
Supply side policy tends to increase the efficiency, competition, and originality to uphold the increase in price of goods. The government might increase/decrease the income tax to seek to manipulate the level of aggregate demand and financial development. Here tax would be using as a demand side policy.
The main characteristics of supply side policy are as under:
- To decrease direct or indirect taxes, this can be done by persuading people to work more and save more, as well as encouraging firms to invest more. For-example: In Singapore, corporate tax was reduced to 20% from 40% decades ago.
- Firms should induce people to work harder and learn as many skills as possible by bonus or profit sharing schemes.
- Reduce the role of government sector and so that private sector increase would play greater role in the business field.
- To assemble and preserve global infrastructure and services of economy.
An economist believes that perhaps aggregate demand is better controlled via monetary policy rather than an over-reliance on exercising fiscal policy. Whereas, in extended term, it is the development of a nation’s supply-side dynamic prospective that gives an economy the elasticity that prevents the acceleration in cost and price inflation.
Question C
What are the main inflationary pressures on the economy at the moment and to what extent might they lead to a re-emergence of higher levels of inflation?
Answer
Presently the government of UK is facing with many inflationary pressures. The main threat is the rising oil prices. Almost all of the manufacturing use oil. Therefore, when oil prices rise, the companies face increased cost of production. In UK, oil is imported, and the global rise in the oil prices will result in imported inflation into the UK hence the goods and services transported by oil will rise in price. This will increase the price of products in UK i.e. inflation will occur. Also the commodities imported from abroad will be more expensive and the consumers in UK will spend on that, which will increase the aggregate demand of UK so basically the extent to which oil price has increased is a definite inflationary pressure on UK.
The second pressure is the income rise. Recently the Government has increased the minimum wage rate. So increased wage rate will result in inflation in the way that workers working on that wage will receive greater income, and then they will spend more, which will result in inflation rise, as consumer spending is a main part of aggregate demand.
The next inflationary pressure is Christmas! During Christmas, and before Christmas, people in UK spend nearly all the money they save on preparations and products. Consumer spending in short will increase with the increase in the aggregate demand of UK.
In China, the goods and services are so cheaply produced and the demand for those goods is in immense at the moment. This is causing certain invisible pressures on economy by which prices would also rise, because if the demand for those goods and services increases more than expectations then china would also increase the prices. This again is a sign for increasing the inflation pressure.
However, prices may rise worldwide; this in fact may not affect UK badly as it would strike to other countries. Over the last eight UK has been implementing its policies very accurately as we saw that the inflation rate was within the target set by the Bank of England.
Question D
What are the economic effects of a high-level inflation?
Answer
Those people who mainly relying on savings are badly affected by inflation because those savings were kept through normal prices but the prices have increased now the case would not be the same, as they will have to pay extra interest rates caused by inflation. Those people on pension earns fixed amount are also effected by inflation because the purchasing power of money will decrease.
The traders and those who have interest to invest in business are likely o loses there interest when there is inflation. Because we have seen that due to inflation prices and demands for goods and services also rise and fall. This would discourage people to invest. In the end if there is less trade in country, there will be more inflation.
Due to inflation balance of trade breaks it affects on export and import as well, export prices will be higher and imports prices will be cheaper. Thus the economy of country will grow slowly are it may be negative.
