Inflation Has Been More Subdued Than In The 1970S What Are The Reasons For This And Will They Endure Essay, Research Paper

Inflation has been more subdued than in the 1970s. What factors explain this and are they likely to endure?

Inflation is a sustained increase in the general price level leading to a fall in the purchasing power of money. It is caused by two major groups of factors: The demand-pull factors, when the total demand for goods and services exceeds the total supply and the cost-push factors, when firms increase prices in order to maintain or protect profit margins.

Inflation in the British economy has over the last decade been more subdued than in the 1970s. This long period of low inflation has been brought about by various factors related to cost-push and demand-pull theory. At the start of the 1990s inflation was high (10.9% as measured by the RPIX) which had been brought on by an increase in aggregate demand and by firms trying to make more profit by passing costs on to the consumer. This high level of inflation was reduced by high interest rates at the end of 1990, as consumers were reluctant to borrow and therefore saved more allowing less spending. Along side these interest rates the global economy was also slowing which had a negative effect on inflation and also helped to bring it down.

The exchange rate was anchored to the low inflation German economy which caused a further dip in inflation because it encouraged British companies to keep their costs under control. The measure of unit labour cost inflation fell from 10 0.3 % in three years. Producers started to absorb costs instead of passing them on to the consumer. As a result of this, by the end of 1993, inflation fell to below 2%.

One of the major reasons that inflation has been so low over the last few years was due to the introduction of an inflation target. This was a figure set by the government to which they would try to keep inflation. It has a number of benefits. Primarily it reduces inflationary expectation, as people believe that inflation will be kept at a low rate then they will not ask for increases in their pay, so unit labour costs are controlled. It also gives a clear target for monetary policy. The decision to let The Bank of England take control of inflation targeting also helped to keep the level of inflation stable because they can act quickly and are not restricted by the politics behind their actions. This allowed for the prompt action of raising interest rates in 1998 in order to control aggregate demand and as a result inflation headed downwards.

These are the reasons that inflation has been so low over that east ten years. But will they endure? The monetary committee of the Bank of England will carry on its task of setting interest rates in order to control inflation and soon it will be totally independent allowing it to work even more efficiently. Obviously our exchange rate is not stilled tied to Germany and so that factor has no bearing on the inflation rate now. But if England joined the Euro it would anchor its exchange rate, which would affect the price level and therefore the inflation rate.

Inflation is very hard to control totally as the causes of it are not easily manipulated. But at the moment the government seem to have all the factors in the right quantity as the rate is not only low but also quite steady. I believe that if there are no major shocks to the economy then inflation is set to stay low.