Sloman (2007:317) states that: the rate of inflation measures the annual percentage increase in prices. The usual measure is that of consumer prices. The government publishes a consumer price index (CPI) each month, and the rate of inflation is the percentage increase in that index over the previous 12 months.
Commodity prices, house prices, food prices, prices after excluding taxes and many others have indices measured then published to calculate the respective rates of inflation. The Retail Price Index (RPI) is a major example which is based on the current retail prices of a basket of goods and services, and published monthly. Listed below are models for CPI and RPI for March 1999 to March 2004.
Chart 1: CPI and RPI March 99- March 04 (% annual rate)
Causes of Inflation
Economic conditions and activities going in the wrong direction all lead to inflation within the UK economy. Inflation is triggered by various instances such as:
- Demand-pull inflation
- Cost-pull inflation
- Expectations of inflation
- Falling exchange rate
- Interaction of demand and cost inflation
Demand pull inflation
In this scenario the total demand within the economy is on a persistent increase resulting in producers of goods and services raising prices, and increasing production; thus a continuous rise in demand would means it becomes inelastic and an increase in price has no effect on demand, putting pressure on inflation. Since production has increased, the requirement for labour has also increased allowing wages to be negotiated for an increase. The price raise is directly influenced by the cost incurred from the increase in production such as the wage increase mentioned above. All these put upward pressure on prices leading to inflation.
Cost push inflation
This inflation is induced by ongoing rises in the total cost to producers of goods and services excluding the effect of the total demand in the economy. The costs are reflected by higher prices passed on to the consumers and a lower level of output by producers. The rate by which prices are raised and the output reduced is related to the elasticity of the goods and services. Hence the less elastic they are the less sales will reduce due to price increase. As a result the suppliers relay the rise in cost to consumers by hiking prices.
Expectations on inflation
As stated earlier, inflation aids in the process of decision making by the government and business organisations. Therefore expected rate of inflation is valuable and used in making decisions. An example if a high rate of inflation is expected during a pay negotiation, the level of pay tends to be high which increase prices reflecting a higher actual rate of inflation.
Falling exchange rate
The falling exchange rate like that during the 1970s, pushes up import prices. This leads to an increase in general prices and cost of living which encourages new wage deals. As wages desperately keep up with hiking prices to maintain a real wage effect, the level of prices is further increased. The scenario further escalates with a balance of trade deficit reducing the value of the currency and pushing up the cost of living, resulting in more wage deal. This process is a spiral that can lead to hyperinflation similar to that in 1973.
Interaction of demand and cost inflation
Both scenarios of demand-pull and cost-push inflation can occur simultaneously, since an increase in total demand and independent factors pushing up costs can raise wages and prices. Prices will continue to rise in both scenarios simultaneously, because government policies will try to improve total demand in line with the cost-push inflation. On the other hand a demand pull-inflation may result in certain strongholds driving up costs.
Inflation over the past ten years
Inflation over the past ten years has been low on an average since 1999, on the whole the major influence during this period has been the fact that CPI services prices have been rising and CPI goods prices have been dropping. The UK market comprises of both domestically produced and imported consumer goods. Through the past ten years their have been various scenarios that have influenced inflation in the UK such as:
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Fall in margin in the distribution sector; at first this resulted in retail goods prices going down even though both domestic and imported goods prices were going up.
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Fall in both domestic and imported goods prices; when this scenario occurs, it is eventually passed on to the retail goods prices keeping inflation low.
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Decrease in import goods prices and a buoyant distribution sector; productivity and growth by distributors has been able to keep inflation low with the help of reduced import prices even though domestic price inflation has been rising.
These factors seem to have been keeping inflation low. There is also the great strength of the world economy which will lift world prices of traded goods, eventually domestic goods will begin to go up giving inflation the balance it needs to keep it positive but at a low level.
Policies
Inflation has been a major macroeconomic problem facing the government in the UK; an example is in the 1980s. We know that CPI goods prices falling due to import prices falling has been a major contributor to low inflation but policies introduced over the years have also kept inflation at a low level. These policies include:
- Fiscal policy
- Monetary policy
- Inflation targeting
- Supply side policy
Fiscal policy
This is a demand side policy involving the government altering the level of expenditure and/or rate of taxes so as to be able to influence aggregate demand in the economy.
Expansionary fiscal policy means the government will increase expenditure or lower taxes in order to inject into the circular flow of money or withdraw from the circular flow of money respectively. The result is an increase in aggregate demand and national income.
Deflationary fiscal policy is used by the government to control inflationary pressures, this is when the government reduce expenditure or raise taxes in order to reduce aggregate demand therefore preventing excessive inflation.
Monetary policy
The Monetary Policy Committee (MPC) of the Bank of England meets monthly to set interest rates. This is because setting the level of interest rates, which is a monetary policy, influences greatly a vast number of macroeconomic variables. In the UK the government set the policy targets, but the Bank of England is given freedom to set interest rates.
Short-term monetary methods are used in controlling inflation;
Altering the money supply; if inflation is rising or predicted to rise, the Bank of England can use open-market operations such as selling treasury bonds to reduce broad money supply. This is as a result of discount houses buying the bonds and in turn reducing the amount of credit they can create which helps to slow inflation.
Manipulating interest rates; the MPC can increase interest rates if it forecast that inflation will be above the set target. This will filter through the economy and reduce aggregate demand because higher interest rates for consumer means higher cost of borrowing, reducing spending, and more savings due to high interest rates and reduced disposable income for those with mortgages.
Inflation targeting
Since 1992 the policy of inflation targeting has been used by both the government and the Bank of England, using monetary policies to keep to the target. First at a range of 1 to 4 per cent for RPIX inflation, then a single point target of 2.5 per cent in 1997. Now it is a 2 per cent target for CPI inflation since late 2003. It is important to know that the Bank of England’s decisions are made on forecast rate of inflation.
Supply-side policy
When inflation is brought about by cost-push factors, supply-side policy can influence the cost factors in the following ways; one by squeezing margins between organisations therefore increasing competition in the supply of goods and services; two by helping to increase productivity and growth through improving the skill of the labour force, or by grants to firms, or by reduced taxes.
Inflationary pressures
There has been a vast variety of factors influencing inflation thereby inflicting inflationary pressures on the UK economy.
Here are a few;
Rising oil prices
The world demand for oil is constantly rising due to world economic growth through countries like China and India. Oil is increasingly becoming scarcer than ever. This is resulting in higher prices through lack of supply and in turn reflecting as inflationary pressures in the UK. This can be seen by the rise in prices on the forecourt.
Increase in food prices
The increase in world demand, plus the strain of drought on grain and the increase in energy and fertilizer prices have all influenced prices of food in the UK. A surge in the power bill has increased production costs of food within the UK with prices being feed through to the consumers. There has also been an effect on prices due to increase in the use of crops for bio-fuels; this has reduced supply of crops for food pushing up prices.
Economic growth
The growth the UK economy has enjoyed can also be attributed to the rise in cost the manufacturers are facing, through both demand and rise in cost of raw materials. The rise in cost are being past on to the consumers at the factory gates, leading to rise in prices of manufactured products, exerting more inflationary pressures on the economy.
All the above inflationary pressures are having a great effect on the economy and if not curbed in the short-run could lead to greater pressures on prices in the long-run giving a base for a re-emergence of higher levels of inflation.
Economic effects of inflation
With higher levels of inflation and more fluctuations, there is a cost to the economy.
These are as follows;
Wealth redistribution; here the income is redistributed in favour of those with bargaining power to gain more pay, rent or profit increase, an example are those with assets, from those with less power, fixed incomes and people paying rates of interest below the rate of inflation., pensioners are badly affected by this redistribution of wealth.
Economic growth; high levels of inflation can cause uncertainty in the business sector when it becomes difficult for organisations to predict their costs and revenue, having such a fluctuating or high level of inflation discourages organisations and there is lack of investments leading to a down turn in economic growth. Monetary policies to curb the inflation may also have a downward effect on economic growth.
Balance of payment; such levels of inflation will affect the prices of exported goods, making them less competitive in the markets and allowing imported goods to become cheaper. This will put the balance of trade in deficit with exports falling and imports rising, effects such as higher interest rates and fall in exchange rate will be noticed.
Other variables like unemployment and government policies can be affected by high levels of inflation and sometimes extra resources are needed to cope with such a situation.
Conclusion
From this report, inflation seems to be a macroeconomic problem that the government have well under control and will not be raging like the bad old days. Inflation may creep up with the way the economy stands at present but would be well under control. These are as a result of the economy still growing and the policies helping to keep inflation within good range of its target.
The poor people in the economy are still suffering the most even though it seems inflation is low because they struggle the most to afford fuel, food and energy which have increased in prices a lot more than the CPI as a whole. This leaves the poorest with less cash in hand and struggling to survive so I believe this is were attention should be paid, by the government rather than on CPI inflation as a whole.
References
Davies B et al (1996). Investigating Economics, Basingstoke: Macmillan Press Ltd
Sloman J (1998). Essentials of Economics, 4ed, Harlow: Pearson Education Limited
Sloman J and Hinde K (1998). Economics for Business, 4ed, Harlow: Pearson Education Limited
Rothbard M N (1963). Americas Great Depression, Part 1, Princeton: D Van Nostrand Co.
Nickell S (2005). Why Has Inflation Been So Low Since 1999? London: Bank of England Monetary Policy Committee and London School of Economics.
Web sites
Chart 1: source: National Statistics Office for CPI and RPI annual % rate march 1999- march 2004