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Causes & Effects ofEffects of Inflation

A2 Economics, November 2010

Causes of inflation

• Inflation is a sustained increase in the general level of prices

• There are many possible causes of price inflation in an economy – for example1. Demand and supply-side causes

2. Inflation from internal and external sources

3. Inflationary effects of government / regulatory intervention in the economy

• Average rates of inflation vary widely across the world across countries at different stages of development

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The consumer price index (CPI)Annual % change in the Consumer Price Index

UK Consumer Price Inflation

5.0

6.0

5.0

6.0

1.0

2.0

3.0

4.0

Pe

rce

nt

1.0

2.0

3.0

4.0

CPI Inflation target = 2%

Source: UK Statistics Commission

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11-1.0

0.0

-1.0

0.0

Mapping the main causes of inflation in the UK

Import Prices

Basic Pay

Bonuses + overtime

Exchange rate / Profit margins

Earnings

Productivity

Unit labour costs

Commodity Prices

Taxes

Rate of inflation

Global Economic Cycle

+ =+

+

Taxes

Profit Margins

Secular Influences(e.g. ICT impact, quality of education)

Economic Cycle

Economic Cycle

Fiscal Policy+

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Demand-pull inflation

• Demand – pull inflation – When there is excess demand for goods and– When there is excess demand for goods and

services

– Positive output gap (where actual GDP > Potential GDP)

– Businesses respond by raising prices to increase profit margins

D d ll i fl ti i t d ith b– Demand-pull inflation associated with boom phase of the cycle (SRAS becomes inelastic)

– Root causes of demand pull inflation are usually monetary in origin (excessive lending / growth of the money supply – monetarist causes)

Main causes of demand pull inflation

• A large depreciation of the exchange rate

• A reduction in direct or indirect taxationA reduction in direct or indirect taxation

• Rapid growth of the money supply as a consequence of increased bank and building society borrowing

• Rising consumer confidence and an increase in the rate of growth of house prices

• Faster economic growth in other countries• Faster economic growth in other countries –providing a boost to UK exports overseas

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Illustrating demand-pull inflationGeneral

Price Level

SRAS1

LRAS

P1

P2

National Income

AD1

Y1 Yfc Y2

AD2

SRAS responds to excess aggregate demand

General Price Level

SRAS1

LRAS SRAS2

P3

P1

P2

P3

National Income

AD1

Y1 Yfc Y2

AD2

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Demand-pull inflation using a non-linear AS curve

General Price Level

LRAS

P1

P2

P3

Real National Income

AD1

SRAS

Y1 Yfc

AD2

Y2

AD3

Inflation and output gap for the UKOutput Gap = Actual GDP - Potential GDP. CPI inflation - annual % change in prices

The Output Gap and Consumer Price Inflation

6.0

8.0

10.0

6.0

8.0

10.0

-4.0

-2.0

0.0

2.0

4.0

Pe

r ce

nt

-4.0

-2.0

0.0

2.0

4.0

CPI Inflation

Output gap

Source: UK Statistics Commission and OECD World Economic Outlook

90 92 94 96 98 00 02 04 06 08 10-8.0

-6.0

-8.0

-6.0

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Cost Push Inflation

• Causes:– External shocks (i.e. commodity price fluctuations)( y )

– A depreciation in the exchange rate (higher import costs)

– Acceleration in wages / unit labour costs in the labour market

• Leads to an inward shift in SRAS curve

• Firms raise prices to protect their profit margins –better able to do this when demand is price inelastic

• “Wages often follow prices” - a second-round effects of an increase in the cost of living

• Rise in actual inflation can lead to an increase in inflationary expectations

Illustrating cost-push inflation

SRAS1

LRASSRAS2

General Price Level

P1

P2

National Income

AD1

Y1 YfcY2

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Illustrating cost-push inflation – with a non-linear SRAS

General Price Level

LRAS

P1

P2

Real National Income

AD1

SRAS1

Y1 Yfc

SRAS2

Y2

AD2

Y3

Oil prices and CPI inflationAnnual % change in the Consumer Price Index and monthly average for Brent Crude

UK Inflation and Crude Oil Prices

100

150

SD

/Ba

rre

l

100

150

Crude Oil Price

3.0

4.0

5.0

6.0

Pe

rce

nt

3.0

4.0

5.0

6.0

Consumer Price Inflation

0

50US

0

50

Source: UK Statistics Commission and IPE

06 07 08 09 100.0

1.0

2.0

P

0.0

1.0

2.0

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Average Earnings and Consumer Prices in the UKAnnual % change in earnings and consumer prices

Wage Growth and Consumer Prices - A Link?

5

6

5

6

Average Earnings

2

3

4

Pe

rce

nt

2

3

4

Consumer price inflation

Source: Reuters EcoWin

00 01 02 03 04 05 06 07 08 09 100

1

0

1

Import prices can have a direct effect on the rate of inflation

Index 2003=100, source: Monthly Digest of Economic Statistics

Index of UK Import Prices

150

175

200

150

175

200

75

100

125

150

Ind

ex

50

75

100

125

150

Total Import Price Index

Import Prices for Fuels

Finished Manufactured Goods

Imports of Goods exc oilImports of Fuels

Imports of finished manufactures

Source: Reuters EcoWin

01 02 03 04 05 06 07 08 09 10

25

50

25

50

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How does the exchange rate affect inflationary pressures?

Exchange rate index (top pane) and inflation (lower pane)

Inflation and the Exchange Rate for the UK

90

100

110

Ind

ex

90

100

110Sterling Exchange Rate Index

3.0

4.0

5.0

6.0

Pe

rce

nt

3.0

4.0

5.0

6.0Consumer Price Inflation

70

80

I

70

80

Source: Reuters EcoWin

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 100.0

1.0

2.0

P

0.0

1.0

2.0

ConsequencesConsequences of inflation

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The costs of inflation

• ‘Taken together, the verdict of economics, history and common sense is that inflation and deflation are costly. It is clear that high inflation – in extreme cases hyperinflation – can lead to a breakdown of the economy. There is now a considerable body of empirical evidence that inflation and output growth are negatively correlated in high-inflation countries. For inflation rates in single figures, the impact of i fl ti th i l l ’inflation on growth is less clear.’

• Mervyn King adapted from a speech entitled “The Inflation Target – Ten Years On” given in 2002

Costs and Consequences of Inflation (1)

• Money loses its value or real purchasing power and people lose confidence in money as the value yof savings is reduced

• Inflation can get out of control - price increases lead to higher wage demands as people try to maintain their living standards. This is known as a wage-price spiral.

• Employees in poor bargaining positions lose out p y p g g pand suffer a reduction in their real living standards and relative income level (i.e. to other groups)

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Costs and Consequences of Inflation (2)

• Inflation can favour borrowers at the expense of savers – because inflation erodes the real value of existing debts- if real interest rates are negative

• Inflation can disrupt business planning and lead to lower capital investment

• Exporters may suffer – if prices in the UK rise higher than those abroad – causing a deterioration in global competitiveness and a worsening of the g p gbalance of payments position

• A possible cause of higher unemployment

• Rising inflation is associated with higher policy interest rates - this reduces trend growth

UK Economic Growth and InflationUK Real GDP Growth and Consumer Price Inflation. annual % change

Economic Growth and Inflation

7.5

10.0

7.5

10.0

-2.5

0.0

2.5

5.0

Pe

rce

nt

-2.5

0.0

2.5

5.0

Consumer price inflation

Real GDP growth

Source: UK Statistics Agency

90 92 94 96 98 00 02 04 06 08 10-7.5

-5.0

-7.5

-5.0

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Anticipated inflation

• When people are able to make accurate predictions of inflation they can takepredictions of inflation, they can take steps to protect themselves from its effects

• For example, trade unions may exercise their collective bargaining power to negotiate with employers for increases innegotiate with employers for increases in money wages so as to protect the real wages of union members

Unanticipated inflation

• Unanticipated inflation occurs when economic agents (people businesseseconomic agents (people, businesses and governments) make errors in their inflation forecasts

• Actual inflation may end up well below, or significantly above expectations causing losses in real incomes and alosses in real incomes and a redistribution of income and wealth from one group in society to another

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Inflation expectationsBank of England/NOP, how do you expect prices to change over the next 12 months?

Inflation Expectations

5.0

6.0

5.0

6.0

1.0

2.0

3.0

4.0

Pe

rce

nt

1.0

2.0

3.0

4.0

How do you expect prices to change over the next 12 months?How has prices changed over the past 12 months?

Source: Bank of England

04 05 06 07 08 09 100.00.0

Some Inflation Web Resources

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