Policies to solve deflation / low inflation

Deflation means a fall in prices (a negative inflation rate). Policy makers should generally be concerned if there is an inflation rate of less than the target of 2%.

For example, in the Eurozone  Jan 2015, the headline inflation rate is -0.2%. Even if we strip away volatile prices like oil, core inflation is 0.8%. This is a very low rate of inflation.

There are many serious potential problems of low inflation / deflation

  • Higher debt burdens,
  • Decline in spending,
  • Higher unemployment.

See costs of deflation for more detail.

 What options are available to overcome deflation?

Monetary policy

The traditional tool of monetary policy is interest rates. If inflation is too low, the Central Bank can try to cut interest rates. In theory, this should boost spending and aggregate demand. For example, lower rates reduce cost of mortgage payments, giving people more to spend.

AD-increase

A simple theory to increase inflation – cut interest rates, boost AD and increase the PL

 

However, there are times when cutting interest rates are not sufficient. In a liquidity trap – zero interest rates may not encourage sufficient spending. For example, after the credit crunch – lower interest rates failed to boost demand sufficiently. Lower interest rates failed to solve low inflation for many reasons:

  • People preferred to save,
  • People took opportunity to pay off debts
  • Banks didn’t want to lend, so firms couldn’t get loans despite low rates
  • Banks didn’t pass the full base rate cut onto consumers.

Unconventional monetary policy

With a failure of interest rates, the traditional tool of monetary policy, Central Banks have need to consider unconventional monetary policy. Some of these policies are relatively untried.

Helicopter drop – print money

In theory, creating inflation should be the easiest thing – just print money and according to the quantity theory of money – we should get inflation. A particular policy for printing money is termed the ‘helicopter drop’ – where the Central Bank gives newly created money to consumers directly. Central Banks have been reluctant to pursue this strategy, presumably because it goes against the mentality of serious Central Bankers and their inflation fighting credentials. But, it would be a solution to deflation. The most challenging aspect would be knowing about much money to print, to get the right amount of inflation.

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Greece austerity

Greece is a very good example of the damage of austerity can do to both economies and the social fabric of a country. Firstly Greek austerity is almost unprecedented in its scope and intensity.

Greece government spending and revenue

greece austerity

Source: Statista

Greek government spending was cut from €120 bn in 2008 to €90 bn in 2014.

To put that into context – the UK years of ‘austerity’ have seen government spending rise from to £522bn in 2007/08 to £722 bn in 2013/14 (UK government spending)

To cut government spending by 25% in nominal terms is quite rare. In addition, the Greek economy was also saddled with other difficulties which have contributed to lower economic growth.

  • Due to higher inflation rates, Greece experienced a decline in competitiveness . Because it was in the Euro it couldn’t devalue and this led to a large current account deficit – lower exports and reduced domestic demand.
  • No control over monetary policy. The ECB increased interest rates in 2011, and have, until very recently, rejected any form of quantitative easing to help boost domestic demand in southern Europe.

Cost of Austerity

The cost of this austerity has been enormous in terms of economics, social and political upheaval.

unemployment-greece

Source: wikipedia

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Reasons for net migration into the UK

The latest stats for UK net migration show an annual net migration of 260,000 (June 2014). This is roughly split between EU and non-EU migrants

  • 142,000 from EU
    • 44,000 of the EU are from the EU8 (most recent EU countries – Poland, Hungary, the Czech Republic, Slovenia, Slovakia, Estonia, Lithuania, and Latvia)
  • 168,000 from non-EU (of which Commonwealth countries account for 62,000)
reasons-formigration-uk

Reasons-for-migration-uk – ONS Migration study Nov. 2014

  • According to data by the ONS, the biggest reason for net migration into the UK is to pursue education studies. This accounts for 153,000 out of the net migration of 260,000 (Nov. 2014)
  • The second biggest reason is work related 61,000 – of which this is split into 41,000 definite job and 24,000 looking for work.
  • The third biggest reason is to join family already living in UK – 54,000
  • Other reasons 13,000 includes vague responses, such as ‘coming back to live’

Asylum seekers

  • Asylum applications (excluding dependants) rose from 4,256 in 1987 to a peak of 84,130 in 2002, and then declined to 23,507 in 2013. (Migration observatory)
  • In 2012, asylum seekers accounted for 10% of net migration
  • In 2013, the rate of asylum seekers in the UK as 0.47 asylum applicants per 1000 people The European level is 0.91 per 1000.

Reasons for migration depend on country of origin

 

  • For recent arrivals (2007-11) study is one of main reasons for migration.
  • Employment and unemployment rates for UK citizens and EU migrants are very similar.

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Impact of Immigration on UK Economy

In the past two decades, the UK has experienced a steady flow of net migrants into the economy. Net migration is a significant factor in the growth of the UK population. But, does this net migration help or hinder the UK economy?

net-migratinon-91-14-UK

Net long-term migration to the UK was estimated to be 260,000 in the year ending June 2014. This compares to net migration of 182,000 in the previous 12 months.

In the past five years, the UK population has been boosted by net migration of around 1,000,000.

Inflows and Outflows

net-migration-outflows-inflows

  • In 2011, the top 3 countries for source of migrants was India, China and Pakistan.
  • The top 3 destinations for people emigrating from  the UK was Australia, India and US.

Impact of Net Immigration on UK Economy

1. Increase in Labour Force

Migrants are more likely to be of working age – such as, students, and those looking for jobs. They may  bring dependants, but generally net immigration leads to an increase in the labour force and increases the potential output capacity of the economy.

2. Increase in aggregate demand and Real GDP

Net inflows of people also lead to an increase in aggregate demand. Migrants will increase the total spending within the economy. As well as increasing the supply of labour, there will be an increase in the demand for labour – relating to the increased spending within the economy. Ceteris paribus, net migration should lead to an increase in real GDP. The impact on real GDP per capita is uncertain.

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Interest Rate Predictions 2015

Bank of England base interest rates are currently 0.5%. Economists are divided about when interest rates will rise. Some point to the evidence of a strong economic recovery to suggest interest rates could rise by mid 2015. Others argue that the strong global deflationary pressures mean that UK inflation is likely to stay very low (currently 0.5%) and therefore interest rates will stay at 0.5% until even 2016.

inflation-base-rates-since-03

When interest rates were cut to 0.5% in 2009, few would have predicted that interest rates would have stayed so low for so long. In the past few years, expectations of rising interest rates have often proved a false dawn. The reasons for a rise in rates have later evaporated. Will 2015 be a similar experience with the long-awaited rise in interest rates delayed again?

Projections for interest rates (Nov 2014)

  • 2015 – 0.8%
  • 2016 – 1.4%
  • 2017 – 1.7%

The Bank of England inflation forecast from Nov 2014, suggests inflation is expected to continue to fall until 2017. They see no immediate rise in inflation.

bank-england-forecast

Latest Bank of England forecast Nov 2014

However since the latest Bank of England inflation report in Nov 2014, inflation has fallen more sharply than expected, and this could delay the time of rising interest rates.

Why are interest rates likely to stay at 0.5% until 2016?

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UK Inflation Rate and Graphs

Current UK Inflation Rate

  • CPI inflation rate: 0.5% (headline rate)
  • (page updated 15 January, 2015)

monthly-inflation-cpi

What is causing the fall in inflation?

  • Lower cost push inflation – falling oil prices
  • Other commodity prices also falling, such as metals, food.
  • Lower energy prices – gas and electricity
  • Low worldwide inflationary expectations. Europe is experiencing deflation and this is keeping inflation low.
  • Supermarket price wars, with big chains, such as Tesco and Sainsbury attempting to maintain market share from Pound Shops and discounters like Lidl
  • Wage growth still weak, despite early signs of some wage growth.
  • Note: RPI inflation is still 1.6%. Also, core inflation stripping out volatile items such as petrol, oil and energy prices is higher than the headline CPI rate.

Historic inflation

uk-RPI-inflation-1948-2014

The current UK inflation rate compares favourable to much of the post-war period. The 1970s frequently saw double digit inflation. In 2014, the annual RPI was 2.2%.

See also: more historical graphs of inflation

CPI and CPIH

  • CPIH – 0.6% in the year to Dec 2014

CPIH is a new experimental index from the ONS. It is based on CPI, plus it includes housing costs, such as mortgage interest payments. Owner occupiers cost (OOH) account for 12% of the CPIH weighting. Mortgage interest payments are the biggest part of OOH. Mortgage interest payments average 10% of household expenditure.

cpi-cpih-inflation

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UK Debt Burden

What is the UK’s debt burden?

Firstly, there are different types of debt to consider

  1. Government debt – See: public sector debt (often referred to as National debt)
  2. Private sector debt – indebtedness of householders, finance sector and non-financial companies.
  3. External debt – the amount we ‘owe’ to other countries

In addition, you might take into account – future liabilities, e.g. pension fund commitments. Also, equally important, is future economic growth, tax revenue and the ability to meet the current debt burden.

Debt  burden as % of income

The most useful way to consider the debt burden. Is to consider:

  1. Debt as a % of income.
  2. Also, the % of income / taxes spent on debt interest payments

Government debt

uk-national-debt

Source: Reinhart, Camen M. and Kenneth S. Rogoff, “From Financial Crash to Debt Crisis,” NBER Working Paper 15795, March 2010. and OBR from 2010.

UK government borrowing fell to record levels in the early 1990s, but since the financial crisis, national debt as a % of GDP has increased to 78% of GDP (2015).

A related to concept to total national debt is the budget deficit. The budget deficit is the annual amount the government is borrowing.

Debt interest payments as % of GDP

Another important consideration is how significant are debt interest payments.

debt-interest-payments-percent-gdo

With low interest rates, the cost of servicing the UK government debt is lower than we might expect. Many economists suggest that when interest rates are low, the government should take advantage and borrow to finance investment.

See also: UK Debt interest payments

The amount spent on debt interest payments is important for understanding the ‘debt burden’ If you take out a mortgage, the crucial thing is not the total amount outstanding, but the percentage of your income that is spent on mortgage monthly payments.

Who is the UK debt burden owed to?

Another important consideration is who does the UK government borrow from?

The majority of UK public sector debt is owned by the UK private sector / Bank of England.

Private sector debt

In addition to government debt it is also important to look at private sector debt. In particular household debt / company debt. For example, at the start of the recession, household debt fell because householders sought to increase savings and pay off their debts, due to low confidence. In this case the government borrowing is partly offsetting the rise in private sector saving.

total-uk-debt

Financial debt is more complicated. The UK tends to have a large share of financial debt as a % of GDP because it has a large finance sector. But, these large liabilities are offset by high financial sector assets. Financial sector debt becomes a problem if assets fall in value. (e.g. during credit crunch)

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How useful is pareto efficiency?

Readers Question: Pareto efficiency occurs (as you say) ‘when it is impossible to make one party better off without making someone worse off’. Assume (and Economics seems to do this a lot) two people live in the world. One is a multi-billionaire and the other has no money at all. If the rich guy gives the other guy a few bob this is not pareto efficient as the former is worse off! Isn’t this complete codswallop? And Pareto won a Nobel Prize for this! Am  I missing something here? What do you think?

Pareto efficiency can have its uses and may form part of the decision making process. But also  it has its limitations.

  • It makes no judgement about the equality of distribution or overall welfare.
  • A distribution of income could be pareto efficient, but not maximise overall social welfare.
  • It could involve some resources being wasted – as long as no one feels worse off.

Because of these limitation it would be a mistake to use it as the final arbiter of a decision or how to manage society.

Is rich man worse off?

Firstly, in the case of the rich man giving a ‘few bob’ to the poor man. Is the rich man actually worse off?

A rich man may get a high utility from this act of philanthropy. He may feel his welfare his higher because he is in a position to give to the poor man. In this case, both are better off.

However, if the billionaire gets no joy from philanthropy, then he may feel he is worse off because he’s given money to a poor man. From a strict pareto point of view, this is pareto inefficient because the billionaire is worse off after this income redistribution.

But, obviously in this case, it would make no sense to use pareto efficiency as a guiding principle. From a utilitarian perspective, overall welfare of society has increased through this income redistribution because of diminishing marginal utility of money. A billionaire wouldn’t really notice not having a few bob, but the poor man could make very good use of it.

Related pages

 

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Ask an Economic Question 2015

You are welcome to ask any questions on Economics. Though you might also like to try google custom search (top right) to see if the topic has been covered before.

I am looking to explain economic principles / ideas/ recent developments in economics. I can’t promise to answer, but will try if it meets the criteria below.

  • Please don’t ask me to do your coursework / assignment e.t.c. (I can usually tell if it is a homework question!)
  • Please don’t ask any maths calculations.
  • The question and answer will be published here where everyone can see it (including your teacher!)
  • I aim to try and simplify economics; as a rough guide I would aim at an understanding similar to a good British A Level student.
  • I am looking to explain economic principles / ideas/ recent developments in economics.
  •  I will answer as a new post, if you leave email address, I’ll usually send quick email. Check home page of blog for new post. With question and answers

If comments are closed: email

mail(at)econoimcshelp.org
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Reasons for rise in value of the dollar

The past few months have seen a rise in the US dollar. The trade weighted index has risen from 95 in 2011 to 111 in Jan 2011. There has been a near 10% rise in the value of the dollar since July of 2014.

us-trade-weighted-index

us-trade-weighted-index – which measures US dollar against a basket of currencies.

Against the Euro, the dollar has been even stronger.

US-Euro

US-Euro. US Fred

One Euro was worth $1.38 in May 2014, but has now has the Euro has fallen to $1.175 (Jan 8, 2015

Reasons for strength of Dollar

  1. Stronger economic recovery in the US. The last economic growth figures Q3 2014 showed very strong growth of 5%. With strong economic growth, unemployment has fallen to 5.9%. This is in marked contrast to the rest of the developed world. The Eurozone in particular is struggling to post anything other than anaemic growth; EU unemployment is nearly double the US rate. Strong growth tends to increase interest rates because of expectations of rising interest rates.
  2. Rising interest rates. The US is emerging from a deep balance sheet recession and liquidity trap – with strong growth and falling unemployment, it has become a matter of when the Fed will consider raising interest rates from the current low of 0.5%. Higher US interest rates compared to the rest of the world will attract capital flows into the US. This will increase the demand for dollars as investors look to save in US dollar. These hot money flows will push up the value of the dollar. Other countries, don’t look ready to raise interest rates yet.
  3. Also, the news that the US will end asset purchases further strengthens the Dollar. Quantitative easing which involves increasing supply of currency, tends to lower the value – because quantitative easing is more liable to increase inflation.
  4. Despite strong economic growth, US inflation is still low at 1.3%, making US goods relatively competitive.
  5. Weakness of the Euro. One of the US main trading partners, the Eurozone is at a very different stage of the economic cycle. Falling oil prices have pushed the Eurozone into deflation (Inflation rate -0.2%). Combined with low growth and high unemployment, there is an expectation that the ECB will try some form of asset purchase / quantitative easing. This is making the dollar more attractive than the Eurozone; the ongoing concerns over Eurozone debt is another factor which will encourage capital flows to the US.
  6. The Eurozone is not the only big economy stuck in recession. Japan is in recession and Latin American countries, such as Brazil are struggling. Even the big two Asian economies of China and India are slowing down.
  7. Falling oil prices. Falling oil prices are generally good for the US economy. It helps to reduce inflation and costs for business. It is true the US has some oil and energy sectors, which will be damaged by low prices. But, the US economy is much broader and is a big consumer of oil. It’s fortunes are definitely not tied to oil prices, like many of its competitors, such as Russia.
  8. Inverse relationship between oil prices and dollar. As oil prices are priced in dollars. Falling oil prices often lead to a rise in the US dollar.

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