FREE ESSAY ON UK INFLATION

UK INFLATION

Macroeconomics
History, causes and costs of Inflation in the UK economy
Before starting to explain inflation it is necessary first to define it. Inflation can be
described as a positive rate of growth in the general price level of goods and services.
It is measured as a percentage increase over time in a price index such as the GDP
deflator or the Retail Price Index. The RPI is a basket of over six hundred different
goods and services, weighted according to the percentage of how much household income
they take up. There are two measurements of this: the headline rate (includes all the
items in the basket) and the underlying rate (RPIX) which excludes mortgage interest
payments. It is the RPIX which is used more often in this country, as a feature of the UK
when compared to the rest of Europe is a very high proportion of owner/occupier
homeowners. This means that many people have mortgages, and as such, changes in interest
rates (to control inflation) can artificially raise the headline rate.
Causes of Inflation
There are two main causes of inflation,
1) Demand Pull Inflation
This is where the total demand for goods and services in the economy exceeds the total
supply. This happens after excessive growth in aggregate demand, and creates an
inflationary gap. Excess demand in the economy drives up prices, and high prices mean
that Suppliers want to produce more units of their product in order to make more money.
To supply more, they must increase their production capacity, and the easiest way to do
this in the short run is to increase the amount of labour they employ. This means that
they are paying more wages, so people will have more disposable income, and hence there
is more demand in the economy.
Demand pull inflation is often monetary in origin: when the money supply grows faster
than the ability of the economy to supply goods and services. This concept is explained
by the Quantity Theory of Money.
The quantity theory of money holds that changes in the general level of prices are
directly proportional to changes in the quantity of money. It is obvious though, that
merely an increase in the supply would have no effect on prices. The increase must be
spent in order for this to happen. This is where velocity of circulation (V) becomes
important. If the total amount of all transactions is T, and the total amount of money is
M, then 
M/T = V
If you add P as the average price level, then you have the Equation of Exchange:
MV = PT 
This tells you that, when V is constant, a change in M will lead to a change in P or T,
or both. If full employment conditions exist, then an increase in T is not possible in
the short run, so an increase in M will result in an increase in P.
If V is variable, an increase in M can be accompanied by an increase in V. This would
cause total spending to rise by much more than the increase in M, which is one of the
causes of high inflation. When prices begin to rise rapidly, people become reluctant to
hold money - they want to exchange it for goods and services as quickly as possible. This
can lead to an inflationary spiral, as demand-pull is aggravated as excess demand (and
hence prices) again increase. 
Monetarists believe that there is a fairly stable relationship between the demand for
money and total income (nominal GDP). The demand for income is seen as being determined
mainly by the transactions motive (the amount of money people hold for day to day living
costs) and for this reason it will be closely related to the level of income.
If you say that the demand for money is a stable function of GDP, it is the same as
saying that V is a stable function of GDP. For example, say that at any moment in time,
people wish to hold money balances equivalent to 25% of GDP, and that the money supply,
is, in fact, equal to 25% GDP. This means that the market for money is in equilibrium. In
this situation, V = 4 (V = M/T). Now assume that the money supply increases whilst the
demand for money is still stable. People will now find themselves holding excess money
balances, because the money supply is greater than 25% GDP: the supply of money has
become greater than the demand for money, and V is less than 4. People will try to reduce
their money holdings by spending on goods and services. The effect of this increased
expenditure is to increase GDP. This process shows that, for a stable V, any increase in
the money supply brings about an increase in the demand for goods and services.
It is the monetarist view that there is a natural rate of unemployment in the economy -
that there is a certain level below which it cannot be reduced because of factors 
such as frictional, voluntary, seasonal, structural and regional types of unemployment.
At any amount of National Expenditure in the AD/AS model before the that level of output
at which the natural rate exists, an increase in expenditure will result only (in the
long run) in an increase in the total value of transactions, and no increase in the
general level of prices (no inflation). However, once GDP reaches that level, any further
increases in it will result only in price increases, and there will be no more gains in
employment. (See diagrams: Appendix 1)
As far as the UK experience goes, the most significant example of demand-pull inflation
in recent years was the Lawson Boom in the late 1980's. Nigel Lawson as Chancellor
brought interest rates down, and this, coupled with Margaret Thatcher's expansionary
fiscal policy (tax cuts, not spending!) caused an expansionary shock - the economy had
had a stable price level, at close to the level of the Natural Rate of Unemployment
(which was high, but the idea was to reduce it). However, a sudden boom in investment
spending (caused by low interest rates) coupled with an equally sudden one in consumption
(resulting from the tax cuts) resulted in greater than intended an expansionary shock to
the system: excess aggregate demand, creating and inflationary gap. Wages rose faster
than productivity, as firms rushed to meet the demand and produce more at higher prices -
this caused costs to rise, and then prices had to rise again: an inflationary spiral.
2) Cost Push Inflation
An increased cost to suppliers (not caused by excess demand) means that they raise their
prices in order to try and retain the same profit margins. When real prices become high,
people start to demand higher incomes. Sometimes firms further increase prices in order
to cover their new higher wage costs. Prices get higher again, and so people again demand
more wages. When this happens repeatedly, it can lead to another inflationary spiral, and
it is what happened to the UK economy in the late 1970's.
In that case, OPEC rapidly and greatly increased the price of crude oil. To begin with,
it was only in response to the falling value of the US dollar, but on the first of April
1979, prices went up by 14.5% (See appendix), and then later on that year they were
raised by 15%. In total, this meant that prices increased from around US$2 per barrel in
1970, to just under $40 in early 1980, with most of these increases having taken place in
only around eighteen months. 
This meant that suddenly costs for almost all sectors of all goods and services markets
had risen drastically, as fuel costs are one of the most necessary and basic types:
nothing can be produced or transported without power or fuel. This meant that prices had
to rise regardless of the level of demand as firms tried to cover increased costs while
keeping normal profit levels. ( See diagrams: Appendix 1)
Another factor in the high level of inflation in the '70's - it reached almost 25% in '75
(see appendix 2) - was the power of the Trade Unions. Because of closed shop practices,
strike threats (and actual strikes; miners, Feb-Mar 1974) and an amenable Government,
Trade Unions were able to increase the price of labour beyond proportional increases in
productivity. It is the wage price spiral that is the most common feature of cost
inflation: an increase in wages that is designed to compensate for an increase in prices
will generate a further increase in prices, and in turn a further increase in wages, and
so on. 
Other types of cost push inflation are 1) those created by indirect taxes, but these will
only result in a one time increase in inflation, as once prices have increased by the
amount of the tax, there is no repeated shock to cause a spiral, and 2) currency
devaluation - in 1967 British import prices were raised by around 15%, but, like
taxation, it was a once and for all effect.
Costs of Inflation
Again, for costs there are two main categories of inflation; 
1) Anticipated Inflation - this is inflation which is predictable, and hence damage
limitation can be exercised to some extent, restricting the costs.
-  Shoe Leather costs - these are incurred when prices are unstable. There is an increase
in search time as people try to discover more about prices. Inflation also increases the
opportunity cost of holding money, so people make more visits to their banks and building
societies, so wearing out their shoe leather.
-  Menu Costs - these are the costs to firms of re-publishing their prices every time
there is a definite price increase. They can be particularly damaging to firms who rely
on catalogues to send bulky price information to customers.
-  The costs of an imperfectly indexed tax system: if tax thresholds are not changed as
nominal wages rise, people who were previously just below the boundaries could actually
end up being taxed more than when they were earning less (nominally).
-  Front end loading - this is the cost of servicing nominal debt contracts.
2) Unanticipated inflation - with this the costs can be much higher. They are as
follows:
-  Redistribution costs between borrowers and lenders. This redistribution occurs when
the real rate of inflation exceeds the real rate of interest, so people who have borrowed
money can actually end up paying back less than the value they borrowed.
-  Distortionary effects
1) Confusions between relative and average price levels
2) Discouraging long term investment projects - if there is too much uncertainty over
future rates of interest and inflation, cost benefit analysis cannot be applied to future
projects and investments, returns cannot be calculated so less investment takes place.
3) Savers and Lenders may demand a risk premium - if they recognise the problem of
redistribution costs, they will want to increase their interest rates to allow for this.
4) Savers and investors may form different expectations of inflation, possibly resulting
in a misallocation of capital: if an entrepreneur with a safe project approaches an
investor who thinks the future is risky, he may be offered a rate of interest that is too
high for him to make sufficient profit, and so the project will be shelved. However, if
an entrepreneur with a risky project approaches an investor who thinks the future safe,
he will be offered a more affordable rate of interest than if inflation was stable - and
hence a misallocation of capital results.
Costs to UK
The costs to the UK of the inflationary spiral of the 70's Oil crises were: inflation of
13.4% in 1979, rising to 18% in 1980. The Government tried to counter this with medium
term (4 year) financial strategy targets, focused on tightening the supply of M3 (notes
and cash in circulation, plus bank deposits) but because a high proportion of M3 is
interest bearing, high interest rates induced people to hold more of it, hence a decline
in M3 velocity. Monetary growth collapsed. The strength of sterling at the time, coupled
with the high North Sea oil prices, meant a massive erosion of UK competitiveness, and
this, together with the crash in monetary growth led to a UK recession. Unemployment
started at 8% in 1981 and reached almost 12% (claimant count see appendices) by 1986.
The specific costs to the UK of the Lawson Boom were very similar - recession and
unemployment. 
In 1986 there was a dramatic fall in oil prices, back down to almost mid 1970's levels.
This acted in the same way as a cut in and indirect tax would - price decreased and
demand increased, and estimations of it's impact on the economy were as high as a
reflation of between 2 and 2.5 % GDP. In 1987 sterling declined in real terms by 15%,
which meant increased UK competitiveness abroad, and so more demand for UK goods and
services. This, combined with financial sector deregulation and innovation led to a
consumption boom. Exchange rate policy at the time was to shadow the Deutschmark, but as
the pound was under upward pressure, interest cuts had be made. As far as domestic demand
was concerned, this was a bad decision, as it further aggravated the problem of
inflation. The expansion in demand became obvious, and so base rates were increased from
a low of 7.5% in 1988 to a high of 15% in late 1989 
Because consumer demand had been initially slow to respond, interest rates went too high,
and by the time they were reduced in October of 1990, the country was starting to enter a
recession: household disposable income was actually negative during 1991, which means
that consumer spending must have been very low. Unemployment, as a lagged indicator of
the state of the economy, didn't catch up until later, but it peaked at around 10.5% in
1993.
Conclusion
The empirical evidence of the correlation between raising interest rates (contracting the
money supply and reducing consumer expenditure and demand) and subsequent falls in
inflation would seen to bear out the Quantity Theory of Money. 
The biggest costs to the UK from the inflation of the'70's and '80's was unemployment
through recession - it was the contractionary policies of the Government which brought
about the slumps in consumption that cause unemployment. It is the Boom and Bust business
cycle which has been a feature of market economies for so long: boom = inflation = high
interest rates = bust.
It is what Margaret Thatcher tried to avoid with the creation of supply side policies to
make the markets more responsive to increases and decreases in demand. The problem has
been that costs of recession (ie unemployment) are lagged - they do not respond until
after the damage has been done, and so, in the example of the Lawson Boom, because
consumer demand did not respond swiftly to interest rate increases, rates were put up too
much, which stifled growth instead of merely slowing it.
Some people are now suggesting that the cycle of boom and bust has ended with the advent
of e-commerce, as more and more firms employ increasingly fewer people, and are far more
responsive to changes in demand. There is some empirical evidence to suggest this as
inflation seems to have been fairly constant for the last few years (see appendix 2).
However, whether this is due to e-commerce, the Bank of England having semi-autonomous
control over interest rates, or some other factor, has yet to be seen.