inflation · • demand‐pull inflation is associated with the boom phase of the business cycle...
TRANSCRIPT
Inflation
Defining inflation
• Inflation is a sustained increase in the average price level of a country
• The rate of inflation is measured by the annual percentage change in the level of prices as measured by the consumer price index
• A sustained fall in the general price level is called deflation – in this situation, the rate of inflation becomes negative
Consumer Price Index (“CPI”)
• The consumer price index is the main measure of inflation for the UK
• The government has set the Bank of England a target for inflation (using the CPI) of 2%
• The aim of this target is to achieve a sustained period of low and stable inflation
• Low inflation is also known as price stability
History of CPI Inflation in the UK
Annual percentage change in the Consumer Price IndexConsumer Price Inflation for the UK Economy
Source: UK Statistics Commission
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 090
1
2
3
4
5
6
7
8
9
Per
cent
0
1
2
3
4
5
6
7
8
9 After a long period of low inflation, the UK
suffered higher inflation during 2008.
However, the recession of 2009 has reduced inflationary pressures and may even lead to a period
of deflation
Inflation (CPI) and Interest Rates
Annual percentage change in the UK Consumer Price Index, the inflation target is 2%Consumer Price Inflation and Interest Rates for the UK
Source: Reuters EcoWin
97 98 99 00 01 02 03 04 05 06 07 08 090
1
2
3
4
5
6
7
8
Per
cent
0
1
2
3
4
5
6
7
8
Consumer Price Inflation
Base Interest Rates
Interest rates are used by the Bank of England as a key weapon to control inflation. The Base Rate fell to a low of 0.5% in 2009 as fears
of deflation and prolonged recession
grow stronger
Two main causes of inflation
Demand pull Cost push
When there is excess demand
When costs rise
Demand Pull Inflation
• Occurs when there is excess aggregate demand in the economy or market
• Businesses respond to high demand by raising prices to increase their profit margins
• Demand‐pull inflation is associated with the boom phase of the business cycle
• Main causes of demand pull inflation– Very fast growth of demand for credit / borrowing– High levels of consumer spending
Possible causes of demand pull inflation
• A depreciation of the exchange rate increases the price of imports and reduces the foreign price of UK exports
• A reduction in direct or indirect taxation ‐ consumers have more disposable income causing more demand
• 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 rates of economic growth in other countries –providing a boost to UK exports overseas
Cost Push Inflation
• Occurs when costs of production are increasing
• Causes:– External shocks (e.g. commodity price fluctuations)
– A depreciation in the exchange rate
– Acceleration in wages
• What happens?– Firms raise prices to protect their profit margins – better able to do this when market demand is price inelastic
– “Wages often follow prices”
– A rise in inflation can lead to rising inflationary expectations
Example of cost‐push: rising import costs
Index 2003=100, source: Monthly Digest of Economic StatisticsIndex of UK Import Prices
Goods, excluding oil, Non-EU Fuels
Finished manufactures: SITC 7 8
Source: Reuters EcoWin
01 02 03 04 05 06 07 08
50
100
150
200
250
300
350
400
Inde
x
50
100
150
200
250
300
350
400
Total Import Price Index
Import Prices for Fuels
Finished Manufactured Goods
UK inflation and oil prices
Annual percentage change in the Consumer Price Index and monthly average for Brent CrudeUK Inflation and Crude Oil Prices
Source: UK Statistics Commission and IPE
00 01 02 03 04 05 06 07 08 09
0.51.01.52.02.53.03.54.04.55.05.5
Per
cent
0.51.01.52.02.53.03.54.04.55.05.5
Consumer Price Inflation
0
20
40
60
80
100
120
140
US
D/B
arre
l
0
20
40
60
80
100
120
140
Crude Oil Price
Inflation ‐ Costs and Consequences (1)
• Money loses its value and people lose confidence in money as the value of 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.
• Consumers and businesses on fixed incomes lose out because the their real incomes falls ‐ employees in poor bargaining positions lose out
Inflation ‐ Costs and Consequences (2)
• Inflation can favour borrowers at the expense of savers – because inflation erodes the real value of existing debts
• Inflation can disrupt business planning and lead to lower capital investment
• Inflation is a possible cause of higher unemployment in the long term – because of a lack of competitiveness
• Rising inflation is associated with higher interest rates ‐ this reduces economic growth and can lead to a recession
What is Deflation?
• Deflation is a period when the general price level falls
• Normally associated with a significant reduction in economic activity (depression / slump)
• Can also occur if the economy is rapidly building its productive potential
Economic & business costs of deflation
• Consumer postpone spending – if they believe prices will go lower (= reduction in demand)
• The real value of debt increases – makes it harder to pay debt off
• Falling asset prices (e.g. housing)• Business profit margins fall (lower selling prices)
Business effects of inflation (1)
Some inflation is good for business!
Industry‐wide price rises enable revenues to grow
Growing revenues + constant gross margin = higher gross profit
Makes using debt as a source of finance cheaper in real terms
What is the price elasticity of demand for the product?
Business effects of inflation (2)
Effect of inflation on revenue?
Price elasticity of demand
• Refers to the responsiveness of demand to changes in price
• When demand is elastic, a price rise leads to a more than proportionate fall off in quantity demanded
• When demand is inelastic, a price rise leads to a less than proportionate fall off in quantity demanded
Price elasticity
• Firms with inelastic price elasticity of demand will be less affected by a rise inflation
• Some firms will be able to absorb price increases by becoming more efficient
• Price inflation will vary from industry to industry – be careful about making generalisations
Inflation and business costs
• A rise in general inflation:– Sales revenue should rise– But workers likely to demand higher pay to compensate for consumer price inflation
– Labour intensive industries more at risk
• Input cost inflation– Cost‐push inflation will vary from industry to industry
– Firms that need to buy significant commodity raw materials may find profit margins squeezed if they cannot pass on increased costs to customers
Expectations of inflation
• Expectations of inflation are important in shaping what actually happens to inflation!
• When people see prices are rising for the everyday items they purchase they start to get concerned about the effects of inflation on their standard of living
• An initial rise in prices triggers higher pay claims as workers look to protect their way of life
Inflation in the news
BBC Recession Tracker – InflationChicken in the basket of UK goods used to measure inflation (BBC news, March 2009)First UK deflation for fifty years (BBC news, April 2009)Inflation articles (Guardian)Two figures, two inflation stories (BBC news, March 2009)Understanding inflation – a user’s guide (The Times, June 2009)
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