Uk Inflation Macroeconomics History, causes and costs of Inflation in the UK economy Before starting to explain inflation it is necessary first to define it. Inflation can be described as a positive rate of growth in the general price level of goods and services. It is measured as a percentage increase over time in a price index such as the GDP deflator or the Retail Price Index. The RPI is a basket of over six hundred different goods and services, weighted according to the percentage of how much household income they take up. There are two measurements of this: the headline rate (includes all the items in the basket) and the underlying rate (RPIX) which excludes mortgage interest payments.
It is the RPIX which is used more often in this country, as a feature of the UK when compared to the rest of Europe is a very high proportion of owner/occupier homeowners. This means that many people have mortgages, and as such, changes in interest rates (to control inflation) can artificially raise the headline rate. Causes of Inflation There are two main causes of inflation, 1) Demand Pull Inflation This is where the total demand for goods and services in the economy exceeds the total supply. This happens after excessive growth in aggregate demand, and creates an inflationary gap. Excess demand in the economy drives up prices, and high prices mean that Suppliers want to produce more units of their product in order to make more money. To supply more, they must increase their production capacity, and the easiest way to do this in the short run is to increase the amount of labour they employ.
This means that they are paying more wages, so people will have more disposable income, and hence there is more demand in the economy. Demand pull inflation is often monetary in origin: when the money supply grows faster than the ability of the economy to supply goods and services. This concept is explained by the Quantity Theory of Money. The quantity theory of money holds that changes in the general level of prices are directly proportional to changes in the quantity of money. It is obvious though, that merely an increase in the supply would have no effect on prices.
The increase must be spent in order for this to happen. This is where velocity of circulation (V) becomes important. If the total amount of all transactions is T, and the total amount of money is M, then M/T = V If you add P as the average price level, then you have the Equation of Exchange: MV = PT This tells you that, when V is constant, a change in M will lead to a change in P or T, or both. If full employment conditions exist, then an increase in T is not possible in the short run, so an increase in M will result in an increase in P. If V is variable, an increase in M can be accompanied by an increase in V.
This would cause total spending to rise by much more than the increase in M, which is one of the causes of high inflation. When prices begin to rise rapidly, people become reluctant to hold money – they want to exchange it for goods and services as quickly as possible. This can lead to an inflationary spiral, as demand-pull is aggravated as excess demand (and hence prices) again increase. Monetarists believe that there is a fairly stable relationship between the demand for money and total income (nominal GDP). The demand for income is seen as being determined mainly by the transactions motive (the amount of money people hold for day to day living costs) and for this reason it will be closely related to the level of income.
If you say that the demand for money is a stable function of GDP, it is the same as saying that V is a stable function of GDP. For example, say that at any moment in time, people wish to hold money balances equivalent to 25% of GDP, and that the money supply, is, in fact, equal to 25% GDP. This means that the market for money is in equilibrium. In this situation, V = 4 (V = M/T). Now assume that the money supply increases whilst the demand for money is still stable. People will now find themselves holding excess money balances, because the money supply is greater than 25% GDP: the supply of money has become greater than the demand for money, and V is less than 4.
People will try to reduce their money holdings by spending on goods and services. The effect of this increased expenditure is to increase GDP. This process shows that, for a stable V, any increase in the money supply brings about an increase in the demand for goods and services. It is the monetarist view that there is a natural rate of unemployment in the economy – that there is a certain level below which it cannot be reduced because of factors such as frictional, voluntary, seasonal, structural and regional types of unemployment. At any amount of National Expenditure in the AD/AS model before the that level of output at which the natural rate exists, an increase in expenditure will result only (in the long run) in an increase in the total value of transactions, and no increase in the general level of prices (no inflation).
However, once GDP reaches that level, any further increases in it will result only in price increases, and there will be no more gains in employment. (See diagrams: Appendix 1) As far as the UK experience goes, the most significant example of demand-pull inflation in recent years was the Lawson Boom in the late 1980’s. Nigel Lawson as Chancellor brought interest rates down, and this, coupled with Margaret Thatcher’s expansionary fiscal policy (tax cuts, not spending!) caused an expansionary shock – the economy had had a stable price level, at close to the level of the Natural Rate of Unemployment (which was high, but the idea was to reduce it). However, a sudden boom in investment spending (caused by low interest rates) coupled with an equally sudden one in consumption (resulting from the tax cuts) resulted in greater than intended an expansionary shock to the system: excess aggregate demand, creating and inflationary gap. Wages rose faster than productivity, as firms rushed to meet the demand and produce more at higher prices – this caused costs to rise, and then prices had to rise again: an inflationary spiral.
2) Cost Push Inflation An increased cost to suppliers (not caused by excess demand) means that they raise their prices in order to try and retain the same profit margins. When real prices become high, people start to demand higher incomes. Sometimes firms further increase prices in order to cover their new higher wage costs. Prices get higher again, and so people again demand more wages. When this happens repeatedly, it can lead to another inflationary spiral, and it is what happened to the UK economy in the late 1970’s. In that case, OPEC rapidly and greatly increased the price of crude oil.
To begin with, it was only in response to the falling value of the US dollar, but on the first of April 1979, prices went up by 14.5% (See appendix), and then later on that year they were raised by 15%. In total, this meant that prices increased from around US$2 per barrel in 1970, to just under $40 in early 1980, with most of these increases having taken place in only around eighteen months. This meant that suddenly costs for almost all sectors of all goods and services markets had risen drastically, as fuel costs are one of the most necessary and basic types: nothing can be produced or transported without power or fuel. This meant that prices had to rise regardless of the level of demand as firms tried to cover increased cos …