2.3.3a Concepts and causes of inflation

Inflation, Deflation and Disinflation Each Describe a Different Movement in the Price Level

1. Inflation is a sustained rise in the general price level.
2. Deflation is a sustained fall in the general price level.
3. Disinflation is a fall in the rate of inflation, so prices still rise but more slowly.

What Each Term Means in Practice

1. Inflation means prices are rising over time.
2. Deflation means prices are actually falling.
3. Disinflation means prices still rise, but at a slower rate.

Why Inflation Erodes the Value of Money

1. When the price level rises, each pound buys less.
2. So inflation erodes the real value of money.
3. This is why price stability is a policy goal.

Keep the Three Terms Distinct

Demand, Costs and the Money Supply All Drive Changes in the Price Level

1. Demand-pull inflation comes from excess aggregate demand pulling up prices.
2. Cost-push inflation comes from rising costs pushing up prices.
3. A monetary explanation adds excessive growth of the money supply.

How Each Cause Works

1. Strong spending can pull prices up when the economy nears capacity.
2. Rising wages or imported costs push firms' costs and prices up.
3. Expectations of higher prices can feed further inflation.

What Causes Deflation

1. Deflation can come from falling aggregate demand.
2. It can also come from rising aggregate supply or a falling money supply.
3. So the same tools explain prices rising or falling.

Match the Cause to the Diagram

Expectations Can Make Inflation Self-Fulfilling

1. If workers and firms expect higher inflation, they build it into wage claims and price rises.
2. Those higher wages and prices then become actual inflation, so the expectation is self-fulfilling.
3. This can create a wage-price spiral that makes inflation persistent and harder to reduce.
4. Anchoring expectations near the target is therefore a key aim of monetary policy.

The Quantity Theory of Money Links the Money Supply to the Price Level

1. The quantity theory of money links the money supply to the price level.
2. It uses Fisher's equation of exchange, $MV=PQ$.
3. Here $M$ is the money supply, $V$ the velocity of circulation, $P$ the price level and $Q$ real national output.
4. Monetarists argue that, if V and Q are stable, a rise in M raises P in proportion.

How the Theory Works

1. The equation says total spending ($MV$) equals the money value of output ($PQ$).
2. If V and Q are fixed, only P can change when M changes.
3. So a faster-growing money supply feeds straight into prices.
4. This is the monetarist account of the cause of inflation.

Questioning the Assumptions

1. Velocity may not be stable if spending habits change.
2. Real output can rise when there is spare capacity.
3. If V or Q move, the link from M to P breaks down.
4. So the proportional result depends on the assumptions holding.

Evaluating How Realistic the Theory Is

1. For the theory: over the long run, high money growth and inflation move together.
2. Against: velocity and real output are not truly constant in the short run.
3. With spare capacity, extra money can raise output instead of prices.
4. On balance, the quantity theory is a useful long-run guide to inflation, but its proportional link holds only if velocity and real output are stable, which is often not the case in the short run.

Test the Assumptions

2.3.3b Consequences and external influences on inflation

Inflation and Deflation Both Create Winners and Losers, While UK Inflation Is Also Shaped by World Prices and Other Economies

1. Inflation affects consumers, workers, savers, borrowers, firms and the government.
2. It can erode real incomes and the real value of savings.
3. It also brings menu costs, shoe-leather costs and fiscal drag, explained below.

Who Wins and Who Loses From Inflation

1. Savers and lenders lose as the real value of money falls.
2. Borrowers gain as the real value of their debt falls.
3. Uncertainty can deter investment and harm competitiveness.
4. Menu costs are the costs to firms of having to change prices often, such as reprinting price lists, menus and labels, which mount up when inflation is high.
5. Shoe-leather costs are the time and effort people and firms spend shopping around and moving money to avoid holding cash that is losing value.
6. Fiscal drag occurs when inflation lifts nominal incomes and pushes people into higher tax bands, so they pay more tax even though their real income has not risen.

Split the Effects by Group

Deflation Can Be More Damaging Than Mild Inflation

1. Deflation is a sustained fall in the general price level.
2. Demand-side deflation, caused by a fall in aggregate demand, is malign.
3. Supply-side deflation, caused by rising productivity and falling costs, is benign.

How Deflation Harms Individuals and the Economy

1. Consumers may delay spending while they wait for lower prices, which weakens demand further.
2. The real burden of debt rises as prices fall, leaving borrowers worse off.
3. Weaker demand squeezes firms' profits, so they cut investment and jobs.
4. Falling demand, prices and incomes can reinforce one another in a deflationary spiral, so central banks treat persistent deflation as a serious threat.

Trace the Spiral

World Commodity Prices Feed Directly Into UK Inflation

1. Many goods and inputs the UK consumes, such as oil, gas, metals and foodstuffs, are priced on world markets.
2. A rise in world commodity prices raises firms' costs and import prices, causing cost-push inflation in the UK.
3. Because the UK is a large net importer of energy and food, external price shocks pass quickly into domestic prices.

Conditions in Other Economies Spill Over Into UK Inflation

1. The UK trades heavily, so inflation and growth abroad feed through to prices at home.
2. Higher inflation among trading partners raises the price of imports, adding to imported inflation.
3. A fall in the exchange rate makes imports dearer and can raise inflation, while a stronger pound lowers import prices.
4. Strong global demand can pull up commodity and export prices, while a global slowdown can ease inflationary pressure.

How Harmful Is Inflation? It Depends on the Rate, Whether It Is Anticipated and Its Cause

1. Low and stable inflation near the 2% target is widely seen as manageable and even helpful, as it lets relative prices and real wages adjust and keeps the economy clear of deflation.
2. Inflation does most harm when it is high, volatile or unanticipated, because it erodes real incomes and savings, creates uncertainty that deters investment and can weaken international competitiveness.
3. The distribution of gains and losses also matters, since inflation tends to redistribute from savers and lenders towards borrowers, so how fair it is depends on who holds debt and who holds savings.
4. The cause shapes the response, as demand-pull inflation may call for tighter domestic policy whereas imported cost-push inflation from world commodity prices is largely outside domestic control.
5. On balance, inflation is not always harmful, but the case for concern grows the higher, less predictable and more demand-driven it becomes, while sustained demand-side deflation can be a greater threat still.