How do economists try to predict inflation?

inflation-prediction

Readers Question: How does the MPC predict future inflation? Inflation is caused by a mixture of demand-pull and cost-push factors. Therefore, the MPC will look at many statistics which give an indication of whether the economy is reaching full employment and causing inflationary pressures. This will include rate of economic growth, unemployment and the amount …

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The Misery Index

misery-index

The misery index (sometimes known as the Economic Discomfort Index EDI ) is simply the sum of the inflation rate plus the unemployment rate. The higher the combined score, the worse the economic situation. The Misery index was developed by economist Arthur Okun. Where Unemployment rate (ut) and the current inflation rate (πt) High unemployment …

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Problems of deflation

deflation-inflation-20s-30s

Deflation is defined as a fall in the general price level. It is a negative rate of inflation. The problem with deflation is that often it can contribute to lower economic growth. This is because deflation increases the real value of debt – and therefore reducing the spending power of firms and consumers. Also, falling …

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Hyper Inflation in Zimbabwe

In 2008, Zimbabwe had the second highest incidence of hyperinflation on record. The estimated inflation rate for Nov 2008 was 79,600,000,000%

zimbabwe-hyper-inflation

That is effectively a daily inflation rate of 98.0. Roughly every day, prices would double. It was also a time of real hardship and poverty, with an unemployment rate of close to 80% and a virtual breakdown in normal economic activity. The hyper-inflation was caused by printing money in response to a series of economic shocks.

(The highest hyperinflation rate was Hungary 1946 with a daily inflation of 195%)

Causes of hyper-inflation in Zimbabwe

  • Government printing money in response to:
    • High national debt
    • Decline in economic output.
    • Decline in export earnings.
    • Price controls which exacerbate shortages.
    • Lack of confidence in government, economy and political life.
    • Expectations of hyperinflation
  • In the late 1990s, the Zimbabwe government introduced a series of land reforms. This involved redistributing land from the existing white farmers to black farmers. But, with little experience, the new farmers struggled to produce food, and there was a large fall in food production.
  • The economy experienced a sharp fall in output (both agricultural and manufacturing), and this caused a collapse in bank lending.
  • The government began increasing the rate at which they were printing money and increasing the money supply. This started with printing money to finance a war in the Congo and also to increase the salaries of officials and soldiers. But, as the economic crises worsened, printing money became a very short-term solution to try and placate people relying on government pay.
  • With the economy in decline, government debt increased. To finance the higher debt, the government responded by printing more money, which caused more inflation. Inflation meant bondholders saw a fall in the value of their bonds and so it was hard to sell future debt.
  • The economy also experienced many shortages of goods.

zimbabwe-inflation-s-d

  • Due to the decline in output, there were shortages of goods, which pushes prices up. Nominal demand was rising because people had more paper money. This combination of more money chasing fewer goods caused very rapid rises in price.  When there is a shortage – prices rise. Combined with printing more money and this shortage of actual goods, prices rose rapidly.

Price control

Ironically, this shortage of supply was made worse by the imposition of price controls. Price controls set the price for basic goods (the idea was to keep prices affordable and stop inflation). But, because the cost of production increased faster than prices, suppliers had little incentive to supply the goods (at least through the official channels). This made the shortage worse and the actual inflation worse.

Expectations

Zimbabwe had high inflation since the mid-1960s. People became accustomed to expecting more inflation. This then becomes self-fulfilling. If people expect hyperinflation, they demand higher wages and push up prices in anticipation of higher inflation in future.

Inflation Rates in Zimbabwe

199616%
199720%
199848%
199956.90%
200055.22%
2001112.10%
2002198.93%
2003598.75%
2004132.75%
2005585.84%
20061,281.11%
200766,212.30%
2008 Jul.231,150,888.87%
2008 Nov79,600,000,000%

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Different types of inflation

different-types-of-inflation

Inflation means a sustained increase in the general price level. The main two types of inflation are

  1. Demand-pull inflation – this occurs when the economy grows quickly and starts to ‘overheat’ – Aggregate demand (AD) will be increasing faster than aggregate supply (LRAS).
  2. Cost-push inflation – this occurs when there is a rise in the price of raw materials, higher taxes, e.t.c

We can also categorise inflation by how fast the price increases are, such as:

  • Disinflation – a falling rate of inflation
  • Creeping inflation – low, but consistently creeping up.
  • Walking/moderate inflation –  (2-10%)
  • Running inflation (10-20%)

Types include of inflation include

different-types-of-inflation

1. Demand-pull inflation

This occurs when AD increases at a faster rate than AS. Demand-pull inflation will typically occur when the economy is growing faster than the long-run trend rate of growth. If demand exceeds supply, firms will respond by pushing up prices.

A simple diagram showing demand-pull inflation

ad increase - inflation
The UK experienced demand-pull inflation during the Lawson boom of the late 1980s. Fuelled by rising house prices, high consumer confidence and tax cuts, the economy was growing by 5% a year, but this caused supply bottlenecks and firms responded by putting up prices. Therefore the inflation rate crept up.

lawson-boom-inflation-growth

This graph shows inflation and economic growth in the UK during the 1980s. High growth in 1987, 1988 of 4-5% caused an increase in the inflation rate. It was only when the economy went into recession in 1990 and 1991, that we saw a fall in the inflation rate. See: Demand-pull inflation.

2. Cost-push inflation

This occurs when there is an increase in the cost of production for firms causing aggregate supply to shift to the left. Cost-push inflation could be caused by rising energy and commodity prices. See also: Cost-Push Inflation

Diagram showing cost-push inflation.
SRAS-shift-left

Example of cost-push inflation in the UK

UK inflation- 2017

In early 2008, the UK economy entered a deep recession (GDP fell 6%). However, at the same time, we experienced a rise in inflation. This inflation was definitely not due to demand-side factors; it was due to cost push factors, such as rising oil prices, rising taxes and rising import prices (as a result of depreciation in the Pound) By 2013, cost-push factors had mostly disappeared and inflation had fallen back to its target of 2%. After the June 2016 Brexit referendum, Sterling fell another 13% causing another period of cost-push inflation in 2017.

Sometimes cost-push inflation is known as the ‘wrong type of inflation‘ because this inflation is associated with falling living standards. It is hard for the Central Bank to deal with cost push inflation because they face both inflation and falling output.

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Who are the winners and losers from inflation?

winners-losers-inflation

Inflation is a continuous rise in the price level. Inflation means the value of money will fall and purchase relatively fewer goods than previously. In summary: Inflation will hurt those who keep cash savings and workers with fixed wages. Inflation will benefit those with large debts who, with rising prices, find it easier to pay …

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Demand-pull inflation

Demand-pull inflation is a period of inflation which arises from rapid growth in aggregate demand. It occurs when economic growth is too fast. If aggregate demand (AD) rises faster than productive capacity (LRAS), then firms will respond by putting up prices, creating inflation. Inflation – a sustained increase in the price level. Demand-pull inflation – …

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Inflation: advantages and disadvantages

inflation-adv-disadvantages

Readers Question: what are the advantages and disadvantages of inflation? Inflation occurs when there is a sustained increase in the general price level. Traditionally high inflation rates are considered to be damaging to an economy. High inflation creates uncertainty and can wipe away the value of savings. However, most Central Banks target an inflation rate …

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