Entries Tagged 'inflation' ↓

Readers Question: If inflation is too much money, too few goods then how come…..Zimbabwe has the world’s highest inflation rate, at more than 100,000%, and just one adult in five is believed to have a regular job? With no job, no money so no demand so…why inflation?

I don’t have much information on the Zimbabwe economy but a likely explanation for the situation in Zimbabwe could be the government printing money and thereby increasing the money supply much faster than Real GDP.

A few years ago, national debt in Zimbabwe increased to over 100% of GDP. To finance the National Debt, the Government started printing money; but, this only devalued the value of existing money and caused prices to rise.

The inflation is also exacerbated by a shortage of supply. Because basic goods are in short supply it is easy for market prices to be increased causing a spiral effect of upwardly rising prices.

Ironically, this shortage of supply has been made worse by the imposition of price controls. These fix prices for basic goods. But, because the cost of production has been increasing faster than prices, suppliers have little incentive to supply (at least to official channels). This makes the shortage worse and therefore the likelyhood of inflation stronger.

• Note: I think that there is ‘weak demand’ rather than ‘no demand’ Some people still have the ability to buy goods; the problem is that the supply of goods is still less than the very ‘weak’ demand.
• Also, the thing here is that there is little ‘effective demand’. i.e. people want to purchase goods, they just don’t have the necessary income to be able to do it. Leading to tragic consequences such as Funeral Costs soar

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Readers Question: What credit can the adoption of central bank independence take for the relative stability of the UK business cycle since 1997?

The MPC, Bank of England,  are responsible for setting interest rates and determining UK monetary policy. They seek to keep inflation close to the government’s target of CPI 2% +/-1 %

Since 1997, the UK has enjoyed a period of unbroken economic growth and low inflation. It appears that the UK has been able to avoid the ‘boom and bust‘ economic cycles that characterised the boost way period – most notably the Lawson boom of the late 80s and following recession.

The statistics on inflation and economic growth are impressive, especially when put in historical context. It is a good question to ask how much we can credit the independence of the Bank of England?

Why the MPC has helped keep inflation on target.

1. They are independent. They are not subject to political pressures. E.g. they are not tempted to cut interest rates just before an election. This used to be a problem for UK economy, with many experiences of boom and bust economic cycles.

2. Monetary Policy is pre-emptive. They try to prevent inflation before it occurs. They predict future inflation trends. If inflation looks to be increasing above the target of 2%+/-1 then they can increase interest rates to reduce consumer spending and keep inflation on track. Continue reading →

Readers Question: Explain how monetary policy works under an inflation targeting Regime.

I have written some answers to this question on previous occassions. These answers should help:

• How MPC set Interest Rates 
• The MPC and the setting of Interest rates 
• MPC and Inflation Forecasts
  

Meaning of Inflation Targetting

Inflation Targetting means that the Central Bank has a sole objective of achieving the Government’s inflation target. This means in theory they do not target other macroeconomic objectives like unemployment and growth (although in practice they may worry about a recession).

It also means they don’t target inflation indirectly. e.g. fixing currency or targetting money supply. Continue reading →

Readers Question: Evaluate the possible consequences of a falling rate of inflation for the performance of the UK economy.

A falling rate of inflation means that prices will be rising at a slower rates.

It depends on why the inflation rate is falling. If inflation falls from 2.5% to 1.5% as a result of falling aggregate demand, then the UK will experience lower economic growth and possibly recession. This will be harmful and lead to higher levels of unemployment.

If the rate of inflation keeps falling the UK may experience deflation, this will cause further problem, when prices fall people are reluctant to spend because goods will be cheaper in the future. Therefore, there is even slower growth (like Japan).

However, if inflation falls because of increased productivity and better technology. This means that the AS curve will shift to the right. It means that the UK will benefit from both lower inflation and higher growth. For example, new computer technology means prices are falling and we benefit from better equipment. Continue reading →

Readers Question: how the unemployment and inflation is related to country’s economy

If we take the example of the UK, we can see differing examples of how unemployment and inflation are related to a country’s economy. The key to this question is what causes unemployment and inflation. There are several different factors, but it is important to consider both demand side and supply side factors.

Unemployment and Economic Growth. The most obvious factor is that higher economic growth will reduce unemployment. Since 1992, the UK has experienced a long period of economic growth, causing a fall in demand deficient unemployment. Unemployment in 2007 was just under 1 million. In 2008, the unemployment rate has continued to fall; it is about 4% of the labour force (depending on which method you use.) However, in the recession of 1981 (negative growth) unemployment rose to 3 million. Unemployment also rose to 3million in 1992.

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Readers Question: what are the advantages and disadvantages of inflation???

The advantages of inflation:

1. Deflation is very harmful. For example, the Japanese economy has suffered lower growth because of deflation. When prices are falling people are reluctant to spend money because they are concerned that prices will be cheaper in the future, therefore, they keep delaying purchases. There are many more cost of deflation in this essay on

is Inflation beneficial?

Disadvantages of Inflation.

Inflation is considered to be a problem when the inflation rate rises above 2%. The higher the inflation, the more serious the problem is.

• In a modern economy, the Government are most concerned about the destabilising impact of inflation.
• Inflationary growth tends to be unsustainable leading to a damaging period of boom and bust economic cycles.
• Inflation tends to discourage investment and long term economic growth.
• See also: Costs of Inflation 

Despite predicted slowdown in UK economic growth, UK inflation in 2008 has slightly increased above the government’s target of 2%.

There is also an increasing gap between CPI inflation and RPI inflation

source: ONS

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Definition of inflation – a sustained increase in the general price level.

If you ever ask an old relative about prices, they will invariable start talking about how dear things are these days.

“I remember the days when you get a fish and chip supper, 2 loaves of bread and pint of bitter and still have change from a shilling…”

Inflation means the value of money decreases. £10 might not seem much today but back in 1800 but in 2007, that £10 would be worth £120.

What cost $10 in 1800, would effectively cost $0.85 today.

If you want to have more fun*, checking how the value of money has changed you can use this inflation calculator

* Hours of fun guaranteed.

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Since Economics is the ‘Dismal Science‘ it may come as no surprise some economists have developed a term known as the misery index.

The misery index is simply the sum of inflation plus unemployment rate. The higher the combined score, the worse the economic situation.

In the UK, at the moment the misery index is relatively low. Unemployment (claimant count) is 3.4%. CPI inflation 2.2%. This gives a combined misery index of 5.6%. Back in the 1980s the misery index was much higher. In 1981, we had unemployment of about 10% and inflation of about 4%, giving a misery index of 14%. At the height of the Lawson boom, inflation reached 11%, with unemployment still persistently high at around 6%.

A lower misery index requires a reduction in both inflation and unemployment. This can only be achieved by supply side improvements which help increase productivity and reduce both structural unemployment and structural inflation.

The Phillips curve suggests there is a trade off between inflation and unemployment, but this trade off can change. E.g rising oil prices could cause cost push inflation, which shift AS to the left causing both inflation and unemployment. This is known as stagflation.

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Yesterday, the Bank of England released its inflation forecasts for 2008 and 2009. It suggests that if base rates are kept at 5.25% then inflation will stay close to 2%. However, if they cut interest rates to 4.5% (as many in the City have been predicting) then inflation is likely to breach the 3% target.

The Bank, therefore, have a difficult balancing act. On the one hand we have rising inflation (from cost push factors, especially food and energy) but we also have a slowing economy.

Although, the Bank are keen to point out the weaknesses of the economy, they seek to avoid the gloom that has surrounded some sectors of the economy. The Bank suggest this year may merely invovle a rebalancing. Sectors that have done well previously will be slowing down. These sectors include:

1. Housing Market
2. Financial sector in city of London
3. Mortgage lending
4. Consumer Spending

However, other sectors which have struggled in the past, could do better in the coming years. These sectors include:

Manufacturing, export sector.

The inflation forecast also came out on another good day of employment figures, with falls in unemployment.

For more details see:

• Mortgage interest rate forecasts
• Bank of England Inflation forecast