Economics help blog – Page 107

Types of deflation

9 December 201923 November 2017 by Tejvan Pettinger

Is deflation good or bad? Mostly experiences of deflation in western economies have been damaging – deflation has been associated with falling rates of economic growth and higher unemployment. However, it is possible to have a different type of deflation – from rapidly improving productivity; then deflation can be consistent with higher rates of economic growth.

The key issue is – what is causing the deflation and if prices are falling – what is happening to real wages and real interest rates?

Deflation caused by lower costs ‘good deflation’

If we have ‘good’ deflation – due to a big increase in productivity, lower costs – then in theory firms will be able to pay real wage increases. With this type of deflation, we are seeing lower prices, but also higher output, higher productivity, higher profits – and hopefully higher real wages. If consumers see lower prices, but they have rising real incomes, then you would expect higher spending because they will have the money to buy these cheaper goods.

sras-shift-right A fall in costs of production lead to lower prices for consumers – but output increases

Example of good deflation 1870-1890

Towards the end of the nineteenth century, the US, UK economies benefitted from a worldwide fall in prices due to the “Second Industrial Revolution”. This included major improvements in productivity:

More efficient steam engines
Improved steel production (Bessemer Steel)
Cheaper cost of railways – railways came of age.
Improved communication.
The transition from agricultural to industrial production.

The US economy grew rapidly in this period – benefitting from the new technology which helped lower costs. An important feature of this period was that although prices fell, wages were constant or rose and so workers saw real wage growth.

Deflation caused by falling demand

Deflation caused by a fall in AD.

If we have ‘bad’ deflation – falling prices caused by weak demand, then firms will be seeing a decline in profitability. In this circumstance, firms will not be increasing wages but trying to cut wages. Also, if firms can’t cut nominal wages, we may see a rise in unemployment (a combination of real wage unemployment and demand deficient unemployment).

Therefore, in this scenario of lower wages / higher unemployment, the falling prices will not be sufficient to encourage spending and higher consumption. Instead, people will be risk-averse trying to save and waiting for prices to fall further.

Costs of deflation

If prices are falling but nominal wages are also falling or stagnant, we tend to get these problems.

Consumers delay purchases. With falling prices, consumers expect prices to be lower in the future, so put off purchasing goods.
Rise in real value of debt. With falling prices and falling wages, it becomes harder to pay off debt and meet debt repayments.
Real wage unemployment. With falling, prices firms can’t afford workers, but if workers resist nominal wage cuts, then there will be real wage unemployment
Higher real interest rates. Interest rates cannot fall below zero, so if there is deflation, the effective real interest rate rises. Therefore, even if the economy is depressed, real interest rates are high – discouraging borrowing and encouraging saving.
Deflationary cycle. In a deflationary cycle, lower demand leads to lower prices, and falling prices cause lower demand, it is a vicious circle.

Example of ‘bad’ deflation – the UK in the 1920s and early 1930s

Unemployment high during the 1920s and early 1930s. See: UK economy in the 1920s

Deflation/low inflation of UK 2010s

Ignoring cost-push factors underlying inflationary pressures in the UK have been low – with inflation falling to zero in 2015. However, a significant reason for this deflation/low inflation is the poor productivity – and consequent stagnant real wages. Inflation is low, but households are becoming worse off.

index-productivity-80-14

Falling prices led to stagnant real GDP

Readers Question: And regardless of the reason, people should put off buying shouldn’t they?

It can depend on consumer confidence and expectations of future wages/employment opportunities. If we have a period of deflationary pressures – low /negative growth, then people may be fearful about future employment opportunities, they will expect low wage growth, and possibly unemployment – therefore, in this circumstances, consumers will be trying hard to be careful in budgeting and spending. If they think prices will fall and their income may decline, then this is an added reason to delay spending.

However, if there is strong growth, low unemployment and rising wages, there is much less need to be careful with spending – therefore, they will be willing to buy now and enjoy their rising real wages.

Balance of payments and Terms of Trade

7 December 201821 November 2017 by Tejvan Pettinger

How can a change in the terms of trade affect the balance of payments ? How can a change in the balance of trade affect the terms of payments ? The terms of trade is the index of export prices divided by index of import prices (*100) The current account balance of payments is primarily …

Benefits and costs of tariffs

10 February 202121 November 2017 by Tejvan Pettinger

Readers Question: what are the benefits and costs of a tariff on consumers, producers, employment levels and the government? The effect of tariffs on consumers Tariffs increase the cost of imports, leading to higher prices (P1 to P2) for consumers and a decline in consumer surplus. For example, UK consumers have lost out from EU …

Low inflation and high growth

26 February 201821 November 2017 by Tejvan Pettinger

Readers question: “Can an economy achieve low unemployment, low inflation and economic growth at the same time?” To achieve low unemployment, low inflation and economic growth at the same time is possible. For example, the UK economy 1993-2006 saw a prolonged period of low inflationary growth. Since early 2000, the Chinese economy has been growing …

Difference between Point and Arc Elasticity of Demand

12 March 201819 November 2017 by Tejvan Pettinger

When calculating elasticity of demand there are two possible ways.

Point elasticity of demand takes the elasticity of demand at a particular point on a curve (or between two points)
Arc elasticity measures elasticity at the midpoint between the two selected points:

Causes of Consumer Spending

26 January 201818 November 2017 by Tejvan Pettinger

Readers Question: What influences consumer spending Consumption is financed primarily out of our income. Therefore real wages will be an important determinant, but consumer spending is also influenced by other factors, such as interest rates, inflation, confidence, saving rates and availability of finance. Interest Rates – Interest Rates influence the cost of borrowing and mortgage …

Japanese National Debt

27 January 201818 November 2017 by Tejvan Pettinger

Readers Question: How is Japan able to run a national debt of nearly 240% of GDP? (from: List of National debt by Country) In 2017, Japanese public sector debt rose to one quadrillion yen ($10.28 trillion) representing 239% of GDP. This compares to 2013, when government debt was 227% of GDP. This is significantly …

Inflation Targeting Pros and Cons

7 January 201816 November 2017 by Tejvan Pettinger

Inflation targeting means Central Banks are responsible for using monetary policy to keep inflation close to the agreed target (usually around 2%).

Since the mid-1990s, inflation targeting has become widely adopted by developed economies, such as UK, US, and the Eurozone. Inflation targets were introduced to help reduce inflation expectations and help avoid the periods of high inflation which destabilised economies in the 1970s and 80s. However, since the recession of 2008, economists have begun to question the importance attached to inflation targets and are worried that a strict commitment to low inflation can conflict with other more important macroeconomic objectives.

Inflation Targets

UK. The Bank of England has an inflation target of CPI = 2% +/-1. They also have a remit to consider wider macroeconomic issues such as output and unemployment
The ECB has a target to keep inflation below, but close to, 2%
The US Federal Reserve has a dual target to keep long-term inflation at 2% and maximise employment.

Benefits of Inflation Targets

Credibility / Expectations. If an independent Central Bank makes a commitment to keep inflation at 2%, people will tend to have lower inflation expectations. Low inflation expectations make it easier to keep inflation low. It becomes a self-reinforcing cycle – if people expect low inflation, they don’t demand high wages; if firms expect low inflation, they are more conscious of increasing prices. WIth low inflation expectations, smaller changes in interest rates can have a bigger effect.
Avoid Boom and Bust. The UK economy has suffered from many ‘boom and bust’ economic cycles. We had a period of high inflationary growth, which later proved unsustainable and led to a recession. An inflation target places a greater discipline on monetary policy and prevents monetary policy becoming too loose – hoping there has been a ‘supply side miracle. For example, in the late 1980s, inflation was allowed to creep upwards due to high growth – but this led to the bursting of boom and the recession of 1991/91. (See: Lawson Boom)
Costs of Inflation. If inflation creeps up, then it can cause various economic costs such as uncertainty leading to lower investment, loss of international competitiveness and reduced value of savings. By keeping inflation close to the target, it avoids these costs and provides a framework for sustained economic growth. See: Costs of inflation for more details
Clarity. An inflation target provides clarity for monetary policy. Alternatives have been tried with less success. For example, in the early 1980s, monetarism suggested trying to target the money supply – but this indirect targeting of inflation proved limited as the link between the money supply and inflation was weaker than expected.

Problems with Inflation Targets

Cost-push inflation may cause a temporary blip in inflation. Just before the recession of 2009, the UK experienced cost-push inflation of 5% due to high oil prices. To target 2% inflation would have required higher interest rates, which leads to lower growth. Some economists argued interest rates should have been cut earlier, and inflation targets were a reason for the delayed easing of monetary policy.

To some extent, the UK and US are willing to tolerate temporary deviations from the inflation target. The Bank of England allowed inflation to be above target during 2009-2012 because it felt the inflation was temporary and the recession was more serious.
However, the ECB have shown greater inflexibility and unwillingness to tolerate temporary blips in inflation. For example, in 2011 the ECB increased interest rates, despite low growth because they were concerned about inflation. The ECB then struggled with deflationary pressures.

2. Central Banks start to ignore more pressing problems. The ECB set monetary policy to keep inflation in the Eurozone on target. Yet, by targetting inflation, they appeared to be downplaying the costs of rising unemployment. In 2011/12, the ECB seemed remarkably unconcerned about the Eurozone’s slide into a double-dip recession. Rather than trying to prevent a prolonged slump, they were fixated on the importance of low inflation.

Inflation above target can impose costs on the economy such as uncertainty, loss of competitiveness and menu costs, but arguably these costs are much less significant than the social and economic costs of mass unemployment. Unemployment in Spain reached 25%, but there was little monetary stimulus in the Eurozone because the ECB is worried about inflation at 2.6% – This is giving low inflation too much priority in times of a recession.