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.

1. 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.
2. 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.
3. 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.

1. 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.
2. 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’.
3. 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.
4. 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.
5. 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:

1. 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.
2. 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.
3. 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!
4. 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.

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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

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.