Recent History, Causes And Costs Of Uk Inflation Essay, Research Paper

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 costs while keeping normal profit levels. ( See diagrams: Appendix 1)

Another factor in the high level of inflation in the ‘70’s – it reached almost 25% in ’75 (see appendix 2) – was the power of the Trade Unions. Because of closed shop practices, strike threats (and actual strikes; miners, Feb-Mar 1974) and an amenable Government, Trade Unions were able to increase the price of labour beyond proportional increases in productivity. It is the wage price spiral that is the most common feature of cost inflation: an increase in wages that is designed to compensate for an increase in prices will generate a further increase in prices, and in turn a further increase in wages, and so on.

Other types of cost push inflation are 1) those created by indirect taxes, but these will only result in a one time increase in inflation, as once prices have increased by the amount of the tax, there is no repeated shock to cause a spiral, and 2) currency devaluation – in 1967 British import prices were raised by around 15%, but, like taxation, it was a once and for all effect.

Costs of Inflation

Again, for costs there are two main categories of inflation;

1) Anticipated Inflation – this is inflation which is predictable, and hence damage limitation can be exercised to some extent, restricting the costs.

 Shoe Leather costs – these are incurred when prices are unstable. There is an increase in search time as people try to discover more about prices. Inflation also increases the opportunity cost of holding money, so people make more visits to their banks and building societies, so wearing out their shoe leather.

 Menu Costs – these are the costs to firms of re-publishing their prices every time there is a definite price increase. They can be particularly damaging to firms who rely on catalogues to send bulky price information to customers.

 The costs of an imperfectly indexed tax system: if tax thresholds are not changed as nominal wages rise, people who were previously just below the boundaries could actually end up being taxed more than when they were earning less (nominally).

 Front end loading – this is the cost of servicing nominal debt contracts.

2) Unanticipated inflation – with this the costs can be much higher. They are as follows:

 Redistribution costs between borrowers and lenders. This redistribution occurs when the real rate of inflation exceeds the real rate of interest, so people who have borrowed money can actually end up paying back less than the value they borrowed.

 Distortionary effects

1) Confusions between relative and average price levels

2) Discouraging long term investment projects – if there is too much uncertainty over future rates of interest and inflation, cost benefit analysis cannot be applied to future projects and investments, returns cannot be calculated so less investment takes place.

3) Savers and Lenders may demand a risk premium – if they recognise the problem of redistribution costs, they will want to increase their interest rates to allow for this.

4) Savers and investors may form different expectations of inflation, possibly resulting in a misallocation of capital: if an entrepreneur with a safe project approaches an investor who thinks the future is risky, he may be offered a rate of interest that is too high for him to make sufficient profit, and so the project will be shelved. However, if an entrepreneur with a risky project approaches an investor who thinks the future safe, he will be offered a more affordable rate of interest than if inflation was stable – and hence a misallocation of capital results.

Costs to UK

The costs to the UK of the inflationary spiral of the 70’s Oil crises were: inflation of 13.4% in 1979, rising to 18% in 1980. The Government tried to counter this with medium term (4 year) financial strategy targets, focused on tightening the supply of M3 (notes and cash in circulation, plus bank deposits) but because a high proportion of M3 is interest bearing, high interest rates induced people to hold more of it, hence a decline in M3 velocity. Monetary growth collapsed. The strength of sterling at the time, coupled with the high North Sea oil prices, meant a massive erosion of UK competitiveness, and this, together with the crash in monetary growth led to a UK recession. Unemployment started at 8% in 1981 and reached almost 12% (claimant count see appendices) by 1986.

The specific costs to the UK of the Lawson Boom were very similar – recession and unemployment.

In 1986 there was a dramatic fall in oil prices, back down to almost mid 1970’s levels. This acted in the same way as a cut in and indirect tax would – price decreased and demand increased, and estimations of it’s impact on the economy were as high as a reflation of between 2 and 2.5 % GDP. In 1987 sterling declined in real terms by 15%, which meant increased UK competitiveness abroad, and so more demand for UK goods and services. This, combined with financial sector deregulation and innovation led to a consumption boom. Exchange rate policy at the time was to shadow the Deutschmark, but as the pound was under upward pressure, interest cuts had be made. As far as domestic demand was concerned, this was a bad decision, as it further aggravated the problem of inflation. The expansion in demand became obvious, and so base rates were increased from a low of 7.5% in 1988 to a high of 15% in late 1989

Because consumer demand had been initially slow to respond, interest rates went too high, and by the time they were reduced in October of 1990, the country was starting to enter a recession: household disposable income was actually negative during 1991, which means that consumer spending must have been very low. Unemployment, as a lagged indicator of the state of the economy, didn’t catch up until later, but it peaked at around 10.5% in 1993.

Conclusion

The empirical evidence of the correlation between raising interest rates (contracting the money supply and reducing consumer expenditure and demand) and subsequent falls in inflation would seen to bear out the Quantity Theory of Money.

The biggest costs to the UK from the inflation of the’70’s and ‘80’s was unemployment through recession – it was the contractionary policies of the Government which brought about the slumps in consumption that cause unemployment. It is the Boom and Bust business cycle which has been a feature of market economies for so long: boom = inflation = high interest rates = bust.

It is what Margaret Thatcher tried to avoid with the creation of supply side policies to make the markets more responsive to increases and decreases in demand. The problem has been that costs of recession (ie unemployment) are lagged – they do not respond until after the damage has been done, and so, in the example of the Lawson Boom, because consumer demand did not respond swiftly to interest rate increases, rates were put up too much, which stifled growth instead of merely slowing it.

Some people are now suggesting that the cycle of boom and bust has ended with the advent of e-commerce, as more and more firms employ increasingly fewer people, and are far more responsive to changes in demand. There is some empirical evidence to suggest this as inflation seems to have been fairly constant for the last few years (see appendix 2). However, whether this is due to e-commerce, the Bank of England having semi-autonomous control over interest rates, or some other factor, has yet to be seen.Bibliography

Introductory Economics – GF Stanlake Chapter 11

Principles of Economics – Lipsey and Chrystal Chapters 26- 32

Macroeconomics – Greenaway and Shaw

www.tutor2u.net – inflation, income and unemployment statistics

www.answersleuth.com/numbers/1970.shmtl – chronology of oil prices

www.thebankofengland.co.uk -The Bank of England – interest rate statistics