Low and Stable rate of inflation IB Economics

Inflation ØInflation is what? ØA persistent rise in average prices in the economy (learn this!!) ØHow is it measured? ØNormally using the CPI – Consumer Price Index ØWhat is the inflation target? ØDepends on the country ØThe UK is 2% CPI ØWatch inflation video ØShow prices have changed over the years Inflation – a persistent increase in the average price level in the economy usually measured with the CPI (Consumer Price Index)

Why worry about inflation? ØThere a significant number of negative consequences associated with high levels of inflation ØLoss of purchasing power Ø If the rate of inflation is 2% the average price of all goods and services in the economy has risen by 2% Ø If your salary/wages stays the same then it means you can buy less goods and services Ø Your purchasing power (the amount you can buy) has been reduced Ø In this case we say that you have had a fall in real income (income adjusted for inflation)

Why worry about inflation? ØLoss of purchasing power Ø If your income was linked to the inflation rate you would automatically get a 2% cost of living increase which means your real income has remained the same Ø If you worked for a company that had a strong union this may be the case but lots of people do not have inflation linked incomes ØSelf employed, weak trade unions, fixed incomes (old people on pensions/unemployed on benefits) ØExpected rates of inflation are important ØIf your company expects 1. 5% inflation and gives you an increase of 1. 5% but then the inflation rate turns out to be 2% your purchasing power will have reduced

Why worry about inflation? ØEffect on saving Ø If you save $1000 in the bank at 4% annual interest you will end up with $1, 040 Ø If the inflation rate is 6% then the real rate of interest (the interest rate adjusted for inflation) will be negative (4% - 6% = -2%) Ø Your savings will not buy as much as they did the year before Ø You would have been better to spend it than save it Ø You will have lost purchasing power Ø Inflation therefore discourages saving Ø People will buy assets such as houses or art which will be worth more Ø As the bank uses savings to lend to others – less saving will mean less funds for investment Ø This may have negative implications for growth

Why worry about inflation? ØEffect on Interest Rates Ø Commercial banks make money from charging interest to people who borrow money Ø If there is a high rate of inflation banks will raise their interest rates to keep the real rate that they earn positive Ø Effect on international competitiveness Ø If a country has a higher rate of inflation than its trading partners its exports will be less competitive Ø Imports from lower-inflation countries will be more attractive Ø This may worsen the balance of payments Ø This could lead to unemployment in export industries and industries that compete with imports

Deflation ØThere is good deflation and bad deflation Ø Good deflation Ø This comes about from the LRAS shifting Ø Output will increase and price levels with fall Ø This assumes that AD remains (ceteris paribus) Ø This will also give a lower level of unemployment (derived demand for labour from the increased demand for goods and services Deflation – a persistent fall in the average price level in the economy usually measured with the CPI (Consumer Price Index)

Deflation Ø Bad deflation Ø This comes about from AD shifting Ø A downwards shift of AD will result in lower price levels but also lower output (less growth) Ø This could lead to an increase in unemployment Ø Demand for goods and services will decrease Ø Labour is a derived demand Ø If people think prices will go down they will put off consumption Ø When they see prices fall this will confirm their thoughts Ø They will further put off consumption and AD will keep falling

Deflation Ø Japan has a problem with deflation Ø Banks collapsed due to bad debts and bad investments in their own stock market Ø People built up precautionary savings in case they lost their jobs Ø This depressed consumption and AD Ø Interest rates were cut to 0. 25% but it didn’t work Ø The damage had been done Ø Consumer and business confidence crumbled with people and firms reluctant to spend Ø Don’t confuse deflation with a falling rate of inflation (this is called disinflation)

Deflation/Disinflation Ø From 1999 to 2000 the inflation rate rose from 1. 2% to 1. 6% Ø From 2000 to 2001 the inflation rate fell from 1. 6% to 1. 3% Ø the average level of prices rose but at a lower rate than the previous year – disinflation Ø In the next two years the inflation rate continued to fall (prices were still rising but by a smaller and smaller amount) Ø In 2004 the country started to experience deflation (the average level of prices fell by 0. 5%) Ø From 2004 to 2005 the country was still in a period of deflation where average prices fell by 0. 3%

Do you understand? Ø Which period of time did Japan experience a) Inflation b) Disinflation c) deflation

Costs of Deflation Ø Although consumers may be pleased with falling prices there are many problems with deflation Ø Deflation is also a bit of an unknown so it is more difficult to deal with than inflation Ø Some economists argue that the costs of deflation are higher than inflation Ø Unemployment Ø If AD is low businesses may lay off workers Ø If prices fall consumers will put off purchasing Ø Firms will have to drop prices to encourage consumption Ø Consumers will again put of purchasing believing that prices will fall further (deferred consumption) Ø Consumer confidence drops further depressing AD Ø This is known as a deflationary spiral Ø Investment will also be put off

Costs of Deflation Ø Costs to debtors Ø Anyone who has taken a loan (including house buyers who have taken a mortgage) suffers from deflation because the value of their debt rises Ø If profits are low businesses will find it difficult to pay back loans Ø There may be many bankruptcies Ø This will make business confidence even worse Play Japan Inflation video

Measuring Inflation - The Consumer Price Index (CPI) Ø The CPI is a weighted price index used to measure the change in the prices of a typical basket of goods and services Ø The contents of the basket are changed each year Ø In the UK they use information from the Family expenditure Survey Ø Changes in weighting reflects changes in spending behaviour (the more that is spent the higher the weighting) Ø In 2008 fruit smoothies, muffins and USBs were included in the basket Family Expenditure Survey: a Ø Microwaves, 35 mm camera film representative monthly survey of UK and CD singles were removed household expenditure used to derive changes in the CPI

Limitations of the consumer price index as a measure of inflation Ø Different population groups experience different rates of inflation Ø The CPI is an average household and not representative of individual households Ø The weighting for tobacco or motoring expenses will be irrelevant for non smokers and those without a car Ø The CPI does not include house prices Ø Mortgage prices will be a high proportion of spend of younger house buyers Ø Many older home owners will have paid off their mortgages Ø The CPI may overestimate inflation Ø Price rises may hide improvements in the quality of goods and services Ø Cars and electrical goods may have gone up in price but this is due to new innovations

Causes of inflation Ø Inflation comes from several sources Ø It can come directly from the domestic economy Ø Price strategies of leading food retailers based on the strength of demand or competitive pressures Ø A rise in VAT cause firm’s production costs to go up and these being passed onto the consumer Ø It can come from external sources Ø Increase in price of crude oil or other imported commodities, foodstuffs and beverages Ø Changes in exchange rates Ø A falling pound against the Euro might cause higher import prices (remember WIDEC? )

Causes of inflation Ø There are 3 main types of inflation that are caused by different things a) Demand pull inflation b) Cost push inflation c) Excess monetary growth Ø As the name suggests demand pull inflation is caused by an increase demand (AD) Ø Most likely to occur when there is little spare capacity in the economy Ø Increase in AD will lead to an increase in prices Ø When does AD increase? Ø When one or more of the components increases Ø Draw a diagram illustrating demand pull

Causes of inflation Ø Cost push inflation occurs as a result of an increase in the costs of production Ø Any increase in a firm’s costs pushes the supply curve up Ø If the cost of an input such as oil that affects the costs of all business in the economy increases the SRAS will shift upwards Ø Things that cause production costs to go up and force firms to raise their prices to maintain profit margins Ø A rise in costs of imported raw materials (e. g. by a fall in the value of the country’s currency) Ø Rising labour costs Ø Higher indirect taxes Ø Wage price spirals

Causes of inflation Ø Cost push and demand pull together Ø Let’s say house prices rise and the wealth effect comes into play Ø The economy has little spare capacity (it is working close to full employment) Ø Consumption increases Ø aggregate demand increases capacity causing demand pull inflation (1) Ø workers will demand higher wages to help them keep their current standard of living Ø This demand for higher wages will cause cost push inflation (2) Ø Higher wages may also give households the illusion that they have more money Ø This will further increase consumption and increase AD (3)

Causes of inflation Ø Excess monetary growth Ø Monetarists (a branch of new classical economists) believe that inflation is caused by excessive increases in money supply Ø If there is more money in the economy there will be higher spending Ø AD will increase Ø Because this is a new classical theory we draw the LRAS vertical Milton Friedman (1912 -2006) was a Ø Increasing money supply (quantitative Monetarist who passionately easing) tends to be a policy of last believed that government resort intervention always causes more Ø In the UK the Bank of England has harm than good recently (2012) decided on a policy of QE because the low interest rates were not encouraging consumption Ø They believe it is safe to do this because there is spare capacity in the economy but are watching the outcome carefully

Reducing inflation Ø The appropriate policy depends on the cause of inflation Ø If the cause is the price of oil then this is an external factor which is out of government’s control Ø If it is demand pull inflation government can try to dampen demand using deflationary/contractionary fiscal or monetary policy Ø Evaluation Ø There are often problems with contractionary policies Ø Increasing taxes, reducing government spending or putting up interest rates are not popular measures Ø There are lags with both fiscal and monetary policy of 1 to 2 years Ø Government spending budgets are developed over a long period of time and may need lengthy legislative procedures to make any changes

Reducing inflation / Evaluation Ø Monetary policy will harm some people in the economy more than others Ø Anyone that has a loan or mortgage and businesses that want to invest Ø Any government that is looking to be reelected will be reluctant to use these measures Ø This is one of the reasons that many developed countries have monetary policy managed by their central bank which is an independent body Ø The UK MPC need to make sure that inflation is kept within +/- 1% of 2. 5% otherwise they have to write a letter to the government explaining why Ø The Fed does not have an official target Ø It is important that people have faith in the central bank to keep inflation rates stable or they will demand higher wages

Reducing inflation / Evaluation Ø Nowadays monetary policy is considered to be the most effective way of managing AD in the economy Ø Interest rates are seen as the best weapon Ø Fiscal policy is not seen as an effective tool for inflation Ø Governments have commitments to the public so it is very difficult to cut spending Ø Plus any cut in G would take a long time to have an effect on price levels. Ø Supply side policies are used to fix cost push inflation (as long as it is a domestic issue) Ø It is really difficult to say which bit of inflation is cost push and which bit is demand pull so policy makers tend to use a mix of solutions

Reducing inflation / Evaluation Ø The biggest issue with reducing AD is the loss of output and hence unemployment Ø Potentially there is a trade off between inflation and unemployment Ø If unemployment is lowered AD will increase causing inflation Ø If inflation is lowered AD will decrease causing unemployment Ø Responsibility for managing AD might be best left to automatic stabilizers of fiscal policy and careful changes in monetary policy carried out by and independent central bank

HL only Calculating Inflation

Using index numbers Ø This is straight forward if you can calculate percentage changes Ø This table shows the made up index of house prices Ø 2005 is the base year Ø In 2006 there is an increase of 8. 4% so the index goes up to 108. 4 Ø In 2007 there is an increase of 20% since 2005 so the index is 120. 0 Ø We need to take more care when working out the percentage change from 2006 to 2007 Ø It is not 11. 6% Ø It is (120 -108. 4)/108. 4 x 100 = 10. 7% Ø (Difference between the two years divided by the original year) Year Index 2005 100. 0 2006 108. 4 2007 120. 0

Using index numbers Ø When we bring several indices together in a basket we have to give each one a weighting Ø The weighting will depend on the proportion of income that is spent on that good Ø If we take this example on average 40% of income is spent on housing so it gets a weighting of 0. 4 Ø To work out the weighted index you just multiply the index by the weight Category Index for year X Weight Index for year X times weight Index for year X +1 Weight Index for year (X+1) times weight Housing 120 0. 4 48 130 0. 4 52 Foodstuffs 105 0. 2 11 Travel 120 0. 2 24 125 0. 2 25 Clothing 120 0. 1 12 110 0. 1 11 Entertainment 125 0. 1 12. 5 130 0. 1 13 1 112 Totals 107. 5

Using index numbers Ø To find out the rate of inflation you need to do the following sum Ø New index – old index divided by old index Ø In this case it would be Index for (X +1) minus Index for X divided by Index for X Ø Multiply by 100 to get the % inflation rate Ø (112 – 107. 5) / 107. 5 = 4. 2% Category Index for year X Weight Index for year X times weight Index for year X +1 Weight Index for year (X+1) times weight Housing 120 0. 4 48 130 0. 4 52 Foodstuffs 105 0. 2 11 Travel 120 0. 2 24 125 0. 2 25 Clothing 120 0. 1 12 110 0. 1 11 Entertainment 125 0. 1 12. 5 130 0. 1 13 1 112 Totals 107. 5

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