Is zero inflation a good thing?

There are various economic costs associated with inflation – uncertainty, decline in investment, redistribution from savers to borrowers – but although there are costs with inflation, is zero inflation actually desirable? Governments usually set an inflation target of around 2%. (UK CPI target is 2% +/-1) There are reasons for targetting inflation of 2% – …

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Why is cost of living in UK so expensive?

Readers Question: Why is cost of living in the UK so expensive? The cost of living depends on: The price of basic necessities – food, fuel, heating, transport, housing/rent, entertainment. The effective cost of living also depends on real wages. It is expensive to live in Nordic countries, but real wages tend to be higher. …

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Velocity of circulation and inflation

Readers Question: When does velocity of money pick up and why will it? Clearly, the reason US inflation worriers have been wrong so far (NB). Is it confidence or policy?

The velocity of circulation / velocity of money refers to how frequently the money stock in an economy is used in a given period.

In the basic money supply equation, we have MV=PY

  • M= Money supply
  • V = Velocity of circulation
  • P = Price Level
  • Y = Income (in other versions, T also used for transactions)

If there is £1,000bn of money in the economy, and the total value of transactions in a year is £1,000bn, then the velocity of circulation is just 1.

If the total value of transactions rises to £3,000bn, this means the £1,000bn of money stock is being used three times in an economy. This gives a velocity of circulation of 3.

Quantitative easing and a fall in the velocity of circulation

monetary-base-cpi

Blue line is the monetary base (one form of money supply). This surge in the monetary base has had no effect on inflation.

During the period of quantitative easing, we saw a big rise in the monetary base, but, inflation didn’t increase. The reason for this is that people didn’t want to spend this extra money. To be more precise, banks didn’t want to lend this extra increase in the money supply, they just kept bigger bank reserves. Therefore, the money supply didn’t filter through to the wider economy.

Velocity of circulation

m1-velocity

The Green line shows a fall in the M1 velocity of circulation at the start of 2009 (wiki)

This is to be expected in a recession. Banks reduce lending, consumers reduce spending, and there is a rise in saving. Therefore, the velocity of circulation falls. This explains why a rise in the money supply doesn’t cause inflation (which it might if the economy was at full capacity)

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Fall in global inflation rates

Since the 1970s, we have seen a fall in average global inflation rates. There have been periods of inflation (often due to rise in oil prices), but the overall trend has seen much lower inflation rates. In the 1970s, inflation was seen as one of the main macro-economic challenges, but now many feel the challenge …

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How can we have economic growth without inflation?

Readers Question: How can a developing country grow without inflation? Economic growth can lead to inflation, for example, if demand rises faster than productive capacity, then we will see rising prices. However, economic growth is compatible with low inflation, and developing economies which can increase productive capacity and general efficiency can see rising living standards …

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GDP deflator

gdp-deflator

GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all new, domestic goods and services in an economy. The GDP deflator regularly updates the type of goods and services used to measure the implicit price deflator – depending on which goods are being bought. e.g.If the price of …

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Different Measures of Inflation

In the UK, there are quite a few different measures of inflation. All measures seek to show the annual change in living costs. However, different measures of inflation give different inflation figures. For example, RPI can often give a higher rate of inflation than CPI. CPI can also be misleading. For example, an increase in VAT would cause CPI to increase, but a core inflation measure like CPI-CT, would stay lower

It is important to be aware of different measures of inflation because the rate of inflation has an important bearing on monetary policy.

Usually, an inflation rate of CPI 4.5% would encourage the Bank of England to raise interest rates. But, if this inflation rate was due to cost-push factors, such as higher taxes, the inflation rate may not be due to overheating in the economy.

Inflation is calculated by:

  • Finding out the most commonly bought goods (e.g. Family expenditure survey)
  • Measuring the change in prices and then applying the weight of the good to the price change.

Different Measures of Inflation

1. Consumer Price Index (CPI) – official measure. Based on the EU HCIP (Harmonised Consumer index prices)

CPI-inflation-rate-uk

  • Includes taxes.
  • Excludes mortgage interest payments and housing costs
  • Includes some financial services not included in RPI

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