Sunday, August 31, 2014

crocodail attack

Direct versus Indirect Taxation

Direct versus Indirect Taxation

Direct taxes – are paid directly to the Exchequer by the individual taxpayer – usually through “pay as you earn”. Tax liability cannot be passed onto someone else

Indirect taxes – include VAT and a range of excise duties on oil, tobacco, alcohol. The supplier can pass on the burden of an indirect tax to the final consumer – depending on the price elasticity of demand and supply for the product.

Arguments For Using Indirect Taxation	Arguments Against Using Indirect Taxation
Changes in indirect taxes can change the pattern of demand by varying relative prices and thereby affecting demand (e.g. an increase in the real duty on petrol)	Many indirect taxes make the distribution of income more unequal because indirect taxes are more regressive than direct taxes
They are an instrument in correcting for externalities – indirect taxes can be used as a means of making the polluter pay and “internalizing the external costs” of production and consumption	Higher indirect taxes can cause cost-push inflation which can lead to a rise in inflation expectations
Indirect taxes are less likely to distort the choices that people have to between work and leisure and therefore have less of a negative effect on work incentives.	If indirect taxes are too high – this creates an incentive to avoid taxes through “boot-legging” – e.g. the booze cruises to France where duty on alcohol and cigarettes is much lower.
Indirect taxes can be changed more easily than direct taxes – this gives policy-makers more flexibility. Direct taxes can only be changed once a year at Budget time	Revenue from indirect taxes can be uncertain particularly when inflation is low or there is a recession causing a fall in consumer spending
Indirect taxes are less easy to avoid, often people are unaware of how much in duty and other spending taxes they are paying	There is a potential loss of welfare from duties e.g. loss of producer & consumer surplus
Indirect taxes provide an incentive to save savings help to provide finance for capital investment	Higher indirect taxes affect households on lower incomes who are least able to save
Indirect taxes leave people free to make a choice whereas direct taxes leave people with less of their gross income in their pockets	Many people are unaware of how much they are paying in indirect taxes – they may be taxed by stealth – this goes against one of the basic principles of a tax system – that taxes should be transparent

The Tax Base

The tax base refers to the number of tax-paying agents in the economy and the amount of income, wealth and spending on which taxes are applied
When an economy is expanding, so does the tax base. There are more people in work, businesses are growing and making more profits. And both prices and incomes tend to rise, all of which leads to a rise in tax revenues flowing into the Treasury
The reverse happens during a recession. Indeed one of the features of the recession has been the slump in tax income for the UK government – a feature of the downturn that has contributed hugely to the rising budget deficit.

Fiscal Drag

Fiscal drag occurs when tax allowances do not rise in line with prices and incomes
The result is that people and businesses end up paying a larger percentage of their incomes in tax and revenues to the government can rise quickly.

Tax competition between nations

Tax competition describes a process where a national government decides to use reforms to the tax system as a deliberate supply-side strategy aimed at attracting new capital investment and jobs into their economy.
The issue has become important in the European Union because some countries including France and Germany complain that poorer countries are using tax competition as an incentive to attractinward investment, yet they are also net recipients of EU structural funds.
If these countries can afford to lower business taxes, can they also afford not to do with the extra EU funding that helps to finance, for example, infrastructural spending required sustaining fast rates of economic growth?
During the 2010 financial crisis in Ireland, some countries were putting pressure on Ireland to cut their low corporation tax rate of 12% as price for their emergency bail-out. Ireland refused to do this.

Flat Rate Taxes

A ‘flat tax’ means that everyone is taxed at just one rate. I.e. everyone pays the same percentage tax on any income earned above the tax threshold. Examples of countries that have moved towards flat rate tax systems include Estonia, Latvia, Poland, Lithuania, Russia, Slovakia and Hungary. Supply-side economists are often fans of flat rate taxes because they think that they will

Help reduce red tape and reduce the resources wasted on tax forms, chasing up non-payers and enforcing tax laws. This would reduce the money spent on administering the tax system.
Boost incentives for people to work, to save (e.g. for retirement) and for companies to use profits to invest - both of which could increase the country’s potential growth rate.
Generate increased tax revenue – based on the idea of the Laffer Curve
A flat tax may make an economy more attractive to foreign investment.

Arguments against

Flat rate taxes are no longer progressive and so the distribution of income and wealth will be more unequal – certainly in the short and medium term.
Flat taxes can form part of a “race to the bottom” with governments competing with each other to offer the lowest rates of tax to entice inward investment and skilled workers.
If tax rates are cut, some people may choose to work less because they can earn the same income from working fewer hours.
There is no guarantee that businesses will engage in more investment and R&D if company taxes are lower – they may simply offer more in the way of dividends to their shareholders!

Friday, August 29, 2014

Globalisation - Gains, Risks & Disadvantages

China stimulates innovation in the West
Apple’s iPhone and iPad were both designed and prototyped in California and then produced in China. Chinese manufacturing competition is increasingly capturing low-skill production while simultaneously fostering high-skill innovation in the West.
About 15 percent of technical change in Europe in the past decade can be attributed directly to competition from Chinese imports, an annual benefit of almost €10 billion to European economies. Firms have responded to the threat of Chinese imports by increasing their productivity—adopting better IT, boosting R&D spending, and increasing patenting.

Source: Von Reenan & Bloom. LSE

Gains from Globalisation

Globalisation can lead to improvements in efficiency and gains in economic welfare.

Trade enhances the division of labour as countries specialise in areas of comparative advantage

Deeper relationships between markets across borders enable and encourage producers and consumers to reap the benefits of economies of scale

Competitive markets reduce monopoly profits and incentivize businesses to seek cost-reducing innovations and improvements in what they sell

Gains in efficiency should bring about an improvement in economic growth and higher per capita incomes. The OECD Growth Project found that a 10 percentage-point increase in trade exposure for a country was associated with a 4% rise in income per capita

Globalisation has helped many of the world’s poorest countries to achieve higher rates of growth and reduce the number of people living in extreme poverty

For consumers globalisation increases choice when buying goods and services and there are gains from a rapid pace of innovation driving dynamic efficiency benefits

Risks and Disadvantages from Globalisation

Globalisation is not an inevitable process and there are risks and costs:

Inequality: Globalisation has been linked to rising inequalities in income and wealth. Evidence for this is a rise in the Gini-coefficient and a growing rural–urban divide in countries such as China,India and Brazil.
Inflation: Strong demand for food and energy has caused a steep rise in commodity prices. Food price inflation (known as agflation) has placed millions of the world’s poorest people at great risk.
Macroeconomic instability: A decade or more of strong growth, low interest rates, easy credit in developed countries created a boom in share prices and property valuations. The bursting of speculative bubbles prompted the credit crunch and the contagion from that across the world in from 2008 onwards. This had negative effects on poorer & vulnerable nations.
In 2007-08, financial crises generated in developed countries quickly spread affecting the poorest and most distant nations, which saw weaker demand and lower prices for their exports, higher volatility in capital flows and commodity prices, and lower remittances.
Threats to the Global Commons: A major long-term threat to globalisation is the impact that rapid growth and development is having on the environment. Threats of irreversible damage to ecosystems, land degradation, deforestation, loss of bio-diversity and the fears of a permanent shortage of water are afflicting millions of the most vulnerable people are vital issues.
Trade Imbalances: Trade has grown but so too have trade imbalances. Some countries are running enormous trade surpluses and these imbalances are creating tensions and pressures to introduce protectionist policies.
Unemployment: Concern has been expressed by some that investment and jobs in advanced economies will drain away to developing countries. Inevitably some jobs are lost as firms switch their production to countries with lower unit labour costs. This can lead to higher levels of structural unemployment and put huge pressure on government budgets causing rising fiscal deficits.
Standardization: Some critics of globalisation point to a loss of economic and cultural diversity as giant firms and global brands come to dominate domestic markets in many countries.

Sovereign Wealth Funds (SWF)

Investment funds run by foreign governments, also called ‘sovereign wealth funds’ have been in existence since the 1950’s. As a result of high commodity prices and the success of export-oriented economies, China, Singapore, Dubai, Norway, Libya, Qatar and Abu Dhabi have all built up a sizeable surplus of domestic savings over investment.

Now some other countries with large reserves of oil and gas are considering setting up their own funds – in August 2012, Tanzania announced it is to set up a sovereign wealth fund. Not all have been successful. Nigeria’s has operated an Excess Crude Account the surpluses from which have been largely used to pay off existing international debts.

China established its official sovereign wealth fund China Investment Corp (CIC) five years ago with the aim of earning high returns by investing abroad the dollars China earns from its exports. In January 2012, CIC’s $410bn sovereign wealth fund, bought an 8.68 per cent stake in Thames Water, the water network that serves London. It also has investment stakes in France’s GDF Suez, Canada’s Sunshine Oil sands and Trinidad and Tobago’s Atlantic Liquid Natural Gas Company.

Sovereign wealth funds are already having an important effect on the UK economy. Singapore's Temasek owns stakes in Barclays and Standard Chartered, while Qatar and Dubai between them own about a third of the London Stock Exchange. The government of Singapore has also built up a 3 per cent stake in British Land. Dubai's sovereign wealth fund, Dubai International Capital (DIC) has invested money in building stakes in UK companies, including Travelodge and the London Eye.

Many sovereign wealth funds have provided an injection of fresh capital for the UK banking system in the wake of the losses sustained from the sub-prime crisis and the credit crunch. The banks have needed to re-capitalize to repair their balance sheets, improve their chances of survival and provide a stronger platform for a recovery in lending to businesses and individuals who need loans.

Geographical Seepage in the World Economy

Geographical seepage occurs because of inter-relationships between economies, supply-chains and financial markets

One example is how developing countries that were really not part of the financial bubble and subsequent crisis of 2007-08 have suffered economically because of the global downturn.

Seepage is partly due to the changing structure of the world economy arising from outsourcing. The share of industrial production in GDP in BRIC nations has been rising - indeed more and more industrial production takes place in emerging markets. So when demand for new cars, iPods and other electronic goods dries up from the richer nations the BRIC nations see a dramatic fall in export growth. And developing nations reliant on exporting commodities to advanced economies will suffer from a fall in demand for and price of their output.

The global credit crisis led to a partial drying up of capital flows into developing countries - one consequence is that some emerging markets find it really hard to get hold of the bank loans needed to finance their continued expansion.

Protectionism & Barriers to Trade

Protectionism - Import Controls

Trade disputes between countries happen because one or more parties either believes that trade is being conducted unfairly, on an uneven playing field, or because they believe that there is one or more economic or strategic justifications for import controls.

Protectionism represents any attempt to impose restrictions on trade in goods and services. The aim is to cushion domestic businesses and industries from overseas competition and prevent the outcome resulting from the inter-play of free market forces of supply and demand. Protectionism can come in many forms including the following:

Tariffs - a tax that raises the price of imported products and causes a contraction in domestic demand and an expansion in domestic supply – for example, the average import tariff on goods entering the Russian economy is 10%, although there will be higher rates for a number of products
Quotas – quantitative (volume) limits on the level of imports allowed or a limit to the value of imports permitted into a country in a given time period (usually one year).
Voluntary Export Restraint Arrangements – where two countries make an agreement to limit the volume of their exports to one another over an agreed period of time.
Intellectual property laws (patents and copyrights)
Technical barriers to trade including product labeling rules and stringent sanitary rules, food safety and environmental standards. These increase product compliance costs and impose monitoring costs on export agencies in many countries. Huge scale vertically integrated transnational businesses can cope with these non-tariff barriers but many of the least developed countries do not have the some technical sophistication to overcome these barriers.
Preferential state procurement policies – where a government favour local/domestic producers when finalizing contracts for state spending e.g. infrastructure projects
Export subsidies - a payment to encourage domestic production by lowering their costs. Soft loans can be used to fund the ‘dumping’ of products in overseas markets. Well known subsidies include Common Agricultural Policy in the EU, or cotton subsidies for US farmers and farm subsidies introduced by countries such as Russia. In 2012, the USA government imposed tariffs of up to 4.7 per cent on Chinese manufacturers of solar panel cells, judging that they benefited from unfair export subsidies after a review that split the US solar industry.
Domestic subsidies – government financial help (state aid) for domestic businesses facing financial problems e.g. subsidies for car manufacturers or loss-making airlines.
Import licensing - governments grants importers the license to import goods.
Exchange controls - limiting the foreign exchange that can move between countries.
Financial protectionism – for example when a national government instructs its banks to give priority when making loans to domestic businesses.
Murky or hidden protectionism - e.g. state measures that indirectly discriminate against foreign workers, investors and traders. A government subsidy that is paid only when consumers buy locally produced goods and services would count as an example. Deliberate intervention in currency markets might also come under this category.

Quotas, embargoes, export subsidies and exchange controls are examples of non-tariff barriers

Tariffs

China joined the WTO in 1991 and since then average import tariffs have been falling on a consistent basis. Our analysis diagram below shows the standard effects of an import tariff on an imported product. The world price before the tariff is Pw and at this price, domestic demand is Qd and domestic supply is Qs.

Because of the tariff, the import price rises to Pw + T. This causes a contraction in demand to Qd2 and an expansion of supply to Qs2. The result is that the volume of imports falls to quantity M. Tariffs have welfare consequences, one of which is that the welfare of consumers who must now purchase the imported product at a higher price has fallen – there is a deadweight loss of consumer surplus. The effects of a tariff on quantities depend on the price elasticity of demand and price elasticity of supply of domestic businesses that have been given a cushion of increased competitiveness by the tariff.

Arguments for Protectionism

Fledging industry argument: Certain industries possess a possible comparative advantage but have not yet exploited economies of scale. Short-term protection allows the ‘infant industry’ to develop its comparative advantage at which point the protection could be relaxed, leaving the industry to trade freely on the international market.
Externalities and market failure: Protectionism can also be used to internalize the social costs of de-merit goods. Or to correct for environmental market failure in the supply of certain imports.
Protection of jobs and improvement in the balance of payments
Protection of strategic industries: The government may also wish to protect employment in strategic industries, although value judgments are involved in determining what constitutes a strategic sector. This might involve attempting to reduce long-term dependence on certain imports
Anti-dumping duties: Dumping is a type of predatory pricing behaviour and a form of price discrimination. Goods are dumped when they are sold for export at less than their normal value. The normal value is usually defined as the price for the like goods in the exporter’s home market. Recent examples of disputes about alleged dumping have included

India complaining about the dumping of bus and truck tires from China and Thailand
EU shoemakers alleging that Chinese and Vietnamese shoe manufacturers have illegally dumped leather, sports and safety shoes in the EU market
In 2009 EU imposed temporary "anti-dumping" taxes on Chinese wire, candles, iron and steel pipes, and aluminum foil from Armenia, Brazil and China.

In the short term, consumers benefit from the lower prices of the foreign goods, but in the longer-term, persistent undercutting of domestic prices might force the domestic industry out of business and allow the foreign firm to establish itself as a monopoly. Once this is achieved the foreign owned monopoly is free to increase its prices and exploit the consumer. Therefore protection, via tariffs on 'dumped' goods can be justified to prevent the long-term exploitation of the consumer.

The World Trade Organisation allows a government to act against dumping where there is genuine‘material’ injury to the competing domestic industry. In order to do that the government has to be able to show that dumping is taking place, calculate the extent of dumping (how much lower the export price is compared to the exporter’s home market price), and show that the dumping is causing injury. Usually an ‘anti-dumping action’ means charging extra import duty on the particular product from the particular exporting country in order to bring its price closer to the “normal value”.

Tariffs are not a major source of tax revenue for the Government that imposes them. In the UK for example, tariffs are estimated to be worth only £2 billion to the Treasury, equivalent to only around 0.5% of the total tax take. Developing countries tend to be more reliant on tariffs for revenue.

Arguments against Protectionism

Market distortion: Protection can be an ineffective and costly means of sustaining jobs.

Higher prices for consumers: Tariffs push up the prices faced by consumers and insulate inefficient sectors from competition. They penalize foreign producers and encourage the inefficient allocation of resources both domestically and globally.
Reduction in market access for producers: Export subsidies depress world prices and damage output, profits, investment and jobs in many developing countries that rely on exporting primary and manufactured goods for their growth.

Loss of economic welfare: Tariffs create a deadweight loss of consumer and producer surplus. Welfare is reduced through higher prices and restricted consumer choice.

Regressive effect on the distribution of income: Higher prices that result from tariffs hit those on lower incomes hardest, because the tariffs (e.g. on foodstuffs, tobacco, and clothing) fall on those products that lower income families spend a higher share of their income.

Production inefficiencies: Firms that are protected from competition have little incentive to reduce production costs. This can lead to X-inefficiency and higher average costs.

Trade wars: There is the danger that one country imposing import controls will lead to “retaliatory action” by another leading to a decrease in the volume of world trade. Retaliatory actions increase the costs of importing new technologies affecting LRAS.

Negative multiplier effects: If one country imposes trade restrictions on another, the resultant decrease in trade will have a negative multiplier effect affecting many more countries because exports are an injection of demand into the global circular flow of income.

Second best approach: Protectionism is a ‘second best’ approach to correcting for a country’s balance of payments problem or the fear of structural unemployment. Import controls go against the principles of free trade. In this sense, import controls can be seen as examples of government failure arising from intervention in markets.

Economic nationalism

Economic nationalism describes policies to protect domestic consumption, jobs and investment using tariffs and other barriers to the movement of labour, goods and capital

The term gained a more specific meaning in recent years after several European Union governments intervened to prevent takeovers of domestic firms by foreign companies. In some cases, the national governments also endorsed counter-bids from compatriot companies to create 'national champions'. Such cases included the proposed takeover of Arcelor (Luxembourg) by Mittal Steel (India). And the French government listing of the food and drinks business Danone (France) as a 'strategic industry' to block potential takeover bid by PepsiCo (USA

Inflation and deflation,IGCSE,GCEO,GCSE, Complete notes

Measuring Inflation

Introduction

The Cost of Living

The cost of living is a measure of changes in the average cost for a household of buying a basket of different goods and services

In the UK there are two measures, the Retail Price Index (RPI) and the Consumer Price Index (CPI)

Price data is used in many ways by the government, businesses, and society in general. They can affect interest rates, tax allowances, wages, state benefits, pensions, maintenance payments and many other 'index-linked' contracts.

CPI Inflation

The consumer price index (CPI) is a weighted price index, which measures the monthly change in the prices of over 600 different goods and services

The weights are revised each year, using information from the Family Expenditure Survey. The expenditure of the highest income households, and of pensioner households dependent on state pensions, is excluded.

Calculating a weighted price index

Category	Price Index	Weighting	Price x Weight
Food	104	19	1976
Alcohol & Tobacco	110	5	550
Clothing	96	12	1152
Transport	108	14	1512
Housing	106	23	2438
Leisure Services	102	9	918
Household Goods	95	10	950
Other Items	114	8	912
		100	10408

Weights are attached to each category and then we multiply these weights to the price index for each item of spending for a given year.

The price index for this year is: the sum of (price x weight) / sum of the weights
So the price index for this year is 104.1 (rounding to one decimal place)

The rate of inflation is the % change in the price index from one year to another. So if in one year the price index is 104.1 and a year later the price index has risen to 112.5, then the annual rate of inflation = (112.5 – 104.1) divided by 104.1 x 100. Thus the rate of inflation = 8.07%.

The UK Inflation Target

Since 2004, the inflation target for the UK has been consumer price inflation of 2.0%

This target is set each year by the Chancellor and it is the task of the Bank of England to meet this target. There is a permitted band of fluctuation of +/- 1%.

In the early years of this decade inflation stayed comfortably within target range but this changed from 2007 onwards. The target was breached for the first time in the spring of 2007 when inflation edged over 3% before falling back. But in 2008 there was a renewed surge in consumer prices that caused CPI inflation to spike up above 5%. And, despite a dip in inflation brought about by falling interest rates and the recession, CPI inflation has remained above target through most of 2010 and 2011 – averaging around 3%.

The government has not made any official change to the inflation target but, as far as monetary policy is concerned, the Bank of England has interpreted the inflation objective flexibly given the highly uncertain economic situation at home and in the global economy. They appear to have been prepared to tolerate a higher rate of inflation as the economy has struggled to emerge from the downturn.

Criticisms of the inflation target

Setting inflation targets came into fashion in the early 1990s. Macroeconomic policymakers were looking for a way of introducing transparency and credibility into monetary and fiscal policy by having a clear final target or objective – namely price stability at a low (positive) rate of inflation.

The hope was that an inflation target would provide an anchor for inflation expectations, giving businesses and employees the confidence that the purchasing power of money would be protected and encouraging long term planning and higher levels of investment.

Whilst inflation targets seemed to work well during a period of global macroeconomic stability, the inflexible nature of targets has come under growing criticism in the last few years.

In respect of the UK, one criticism has been that the chosen inflation measure and target (CPI inflation of 2%) was not designed to deal with inflation shocks from abroad which, in themselves were not the result of whether UK policy interest rates were at the right level.

A few years back when many businesses were outsourcing and off shoring and China and other emerging markets were making big inroads into world trade, there was a collapse in the price of manufactured goods from DVD players to freezers, kettles and iPods. This led to a fall in consumer prices fell relative to wages and profits boosting people’s spending power. One city economist talked about the“real product wage” – i.e. what goods and services could be bought with £100 of wage income.

This heralded a period when official CPI inflation was below the 2% target; indeed policy-makers focussed their attention on preventing price deflation. To prevent this from happening required a boost to domestic spending through a combination of lower interest rates and an expansionary fiscal policy. Cheaper interest rates encouraged consumer borrowing and also acted as a stimulant to the UK property market. In the short term this boosted AD and GDP growth but at the expense of causing big imbalances – shown by a falling savings ratio, huge levels of personal sector debt, and an unsustainable housing boom.

Fast forward to 2006-08 when booming emerging market countries were contributing to a sudden and sharp rise in world commodity prices, leading to a burst of cost-push inflationary pressures in the UK. This time, CPI inflation surged above the target but once more for reasons that were not to do with what was happening domestically – inflation was being driven by external rather than home-grown headwinds. The response of the Bank of England was to ‘tighten’ policy by raising interest rates and this did much to bring down the housing market.

Thus some economists believe that a narrow inflation-targeting framework has introduced a "stop-go" element into the British economy that has made our cycle more volatile.

Limitations of the Consumer Price Index as a measure of inflation

The CPI is a thorough indicator of consumer price inflation for the British economy but there are some weaknesses in its usefulness for some groups of people. This has become an important issue both when CPI inflation has been well above target.

The CPI is not fully representative: Since the CPI represents the expenditure of the ‘average’ household, it will be inaccurate for the ‘non-typical’ household, for example, and 14% of the index is devoted to motoring expenses - inapplicable for non-car owners. We all have our own ‘weighting’ for goods and services that does not coincide with that assigned for the consumer price index.
Housing costs: The ‘housing’ category of the CPI records changes in the costs of rents, property and insurance, repairs and accounts for around 16% of the index. Housing costs vary from person to person, from the young house buyer, to the older householder who may have paid off the mortgage.
Changing quality of goods and services: Although the price of a good or service may rise, this may be accompanied by an improvement in quality. It is hard to make price comparisons of electrical goods because new AV equipment is so different from its predecessors. In this respect, the CPI may over-estimate inflation. The CPI is slow to respond to the emergence of new products and services.

One of the big issues in recent times has been the difference in measured inflation between the Consumer Price Index (CPI) and the Retail Price Index (RPI). The latter includes mortgage interest costs in its calculation and is therefore more sensitive to changes in the cost of mortgage borrowing.

Introduction

Analysing the Consequences of Inflation

High and volatile inflation has economic and social costs.

Anticipated inflation:

When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects.
Trade unions might use their bargaining power to negotiate for increases in money wages to protect the real wages of union members.
Households may switch savings into accounts offering a higher rate of interest or into other financial assets where capital gains might outstrip price inflation.
Businesses can adjust prices and lenders can adjust interest rates. Businesses may also seek to hedge against future price movements by transacting in “forward markets”. For example, many airlines buy their fuel months in advance as a protection or ‘hedge’ against fluctuations in world oil prices.

Unanticipated inflation:

When inflation is volatile, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future.
Unanticipated inflation occurs when people, businesses and governments make errors in their inflation forecasts. Actual inflation may end up below or above expectations causing losses in real incomes and a redistribution of income and wealth from one group to another

Money Illusion

People often confuse nominal and real values because they are misled by the effects of inflation.
For example, a worker might experience a 6 per cent rise in his money wages – giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income.
Money illusion is most likely to occur when inflation is unanticipated, so that people’s expectations of inflation turn out to be some distance from the correct level.

The Economic Costs of Inflation

We must be careful to distinguish between different degrees of inflation, since low and stable inflation is less damaging than hyperinflation where prices are out of control.

Impact of Inflation on Savers: When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if interest rates are lower than inflation – leading to negative real interest rates. This has certainly happened in the UK during 2009-2011.
Inflation Expectations and Wage Demands: Price increases lead to higher wage demands as people try to maintain their real living standards. This process is known as a ‘wage-price spiral’.
Arbitrary Re-Distributions of Income: Inflation tends to hurt people in jobs with poor bargaining positions in the labour market - for example people in low paid jobs with little or no trade union protection may see the real value of their pay fall. Inflation can also favour borrowers at the expense of savers as inflation erodes the real value of existing debts.
Business Planning and Investment: Inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs - and this may reduce planned investment spending.
Competitiveness and Unemployment: Inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance.

Benefits of inflation

Can inflation have positive consequences? The answer is yes although much depends on what else is happening in the economy. Some of the potential advantages of benign inflation are as follows:

Higher revenues and profits: A low stable rate of inflation of say between 1% and 3% allows businesses to raise their prices, revenues and profits, whilst at the same time workers can expect to see an increase in their pay packers. This can give psychological boost and might lead to rising investment and productivity.
Tax revenues: The government gains from inflation through what is called ‘fiscal drag effects’. For example many indirect taxes are ad valorem in nature, e.g. VAT at 20% - so as prices rise, so does the amount of tax revenue flowing into the Treasury.
Cutting the real value of debt: Low stable inflation is also a way of helping to reduce the real value of outstanding debts – there are many home owners with huge mortgages who might benefit from a period of inflation to bring down the real burden of their mortgage loans. The government too might welcome a period of higher inflation given the huge level of public sector debt!
Avoiding deflation: Perhaps one of the key benefits of positive inflation is that an economy can manage to avoid some of the dangers of a deflationary recession (discussed in the next chapter)

Factors Influencing Inflation

Introduction

Overview of the factors influencing the rate of inflation
The diagram below summarises some of the key influences on inflation. Reading from left to right:
Average earnings comprise basic pay + income from overtime payments, productivity bonuses and other supplements to earned income.
Productivity measures output per person employed, or output per person hour. A rise in productivity helps to keep unit costs down.
The growth of unit labour costs is a key determinant of inflation in the medium term.
Additional pressure on prices comes from higher import prices, commodity prices (e.g. oil, copper and aluminium) and also the impact of indirect taxes such as VAT and excise duties.
Prices also increase when businesses decide to increase their profit margins. They are more likely to do this during the upswing phase of the economic cycle. Conversely inflationary pressures decline in a recession when businesses have far more spare capacity and may decide to offer deep price discounts to their customers to get rid of unsold stock.

The wage price spiral – “expectations-induced inflation”

Rising expectations of inflation can be self-fulfilling
If people expect prices to continue rising, they are unlikely to accept pay rises less than their expected inflation rate because they want to protect the purchasing power of their incomes
When workers are looking to negotiate higher wages, there is a danger of a ‘wage-price spiral’ that then requires the introduction of deflationary policies such as higher interest rates or an increase in direct taxation.

Deflation

Introduction

Deflation is a period when the general price level falls i.e. the cost of a basket of goods and services is becoming less expensive
It is normally associated with falling AD causing a negative output gap (actual GDP < potential GDP)
Deflation can be caused by an increase in productive potential, which leads to an excess of aggregate supply over demand
AD-AS diagrams showing two possible causes of deflation are shown below

Possible Economic Costs of Deflation

Holding back on spending: Consumers may opt to postpone demand if they expect prices to fall further in the future. If they do, they might find prices are 5 or 10% cheaper in 6 months.
Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on consumer confidence and people’s willingness to spend.
The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices. For example UK policy interest rates were slashed to 0.5% in 2009 but realistically they cannot go any lower. If inflation is negative, the real cost of borrowing increases.
Lower profit margins: Lower prices can mean reduced revenues and profits for businesses - this can lead to higher unemployment as firms seek to reduce their costs by shedding labour.
Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence – leading to further declines in aggregate demand.

Benign Deflation
If falling prices are caused by higher productivity, as happened in the late 19th century, then it can go hand in hand with robust growth. On the other hand, if deflation reflects a slump in demand and persistent excess capacity, it can be dangerous, as it was in the 1930s, triggering a downward spiral of demand and prices. If the falling prices are simply the result of improving technology or bettermanagerial practices, that is fine.
Malign Deflation
Malign deflation occurs when prices fall because of a structural lack of demand which creates huge excess capacity in an economic system. If there is a slump in demand, companies go out of business and sack people, and hence demand falls again – the negative multiplier effect starts to have its effect.

John Maynard Keynes on deflation
A recession puts downward pressure on prices and wages – but wages tend to be sticky downwards (people resist having their pay cut)
So if prices are falling but wages are not, business profits will suffer and this could lead to a huge rise in unemployment.
Irving Fisher on deflation
Central banks can only cut nominal interest rates to zero per cent but if prices and wages are falling, real interest rates will rise and the real value of existing business and household debt will increase
During a period of recession and deflation, there is a strong incentive for people to use any rise in real incomes to save and pay down some of their debts rather than spend on new goods and services.

Macroeconomic policies at a time of deflation
A number of options are available for policy-makers when an economy tilts into deflation.
Monetary Policy

Interest rates: Deep cuts in interest rates can be made to stimulate the demand for money and thereby boost consumption. Most central banks around the world have responded to the global recession by slashing official policy rates, in the UK from 5.5% to 0.5%. But this is not always an effective strategy for reducing the risks of deflation:

If consumer confidence is low, the impact of a monetary stimulus might be weak as people are more likely to save any added income to enable them to pay off accumulated debt.
If asset prices are falling, the demand for cash savings will remain high – therefore consumption may not respond to lower interest rates.
There are limits to how far monetary policy can go in boosting demand because nominal interest rates cannot fall below zero.

Quantitative Easing – The Bank of England started this process in March 2009 and expanded it in October 2011. In total (so far) QE has involved £275bn of asset purchases designed to boost lending by the banking system. To some it is best explained as the process of printing money in the hope that, by injecting it into the economy, people and companies will be more likely to spend. If they are more likely to spend, there is a chance that output and employment will respond.

Fiscal Policy
Keynesian economists believe that fiscal policy is a more effective instrument of policy when an economy is stuck in a deflationary recession
The key Keynesian insight is that a market system does not have powerful self-adjustments back to full-employment after there has been a negative economic shock
Keynes talked of persistent under-employment equilibrium – an economy operating in semi-permanent recession leading a persistent gap between actual demand and the potential level of GDP. Keynes argued that this justified an exogenous injection of aggregate demand as a stimulus to get an economy on the path back to full(er) employment and to prevent deflation.
A fiscal expansion of AD can come directly through higher government spending and/or an increase in borrowing. Secondly the threat of deflation might be reduced through lower direct taxes to boost household disposable incomes. Both of these strategies seek to boost incomes and inject extra spending power into the circular flow of income and spending.
The tax cuts might be announced as temporary to deal with a specific deflationary threat. But again there may be limits to the effectiveness of fiscal policy in these circumstances:

There are long term consequences for the size of the national debt
Low consumer and business confidence might again reduce the impact of any fiscal stimulus.