Topic 4: Inflation, Unemployment & Economic Policy: Inflation Flashcards
What is inflation?
Inflation is a rise in the price level; deflation refers to a fall
What is the price level?
The average change in the price of goods and services in the economy
How do governements measure the rate of inflation? and example from UK
Price indices e.g. The Office for National Statistics (ONS) publishes a ‘consumer price index’ (CPI)
Explain the Consumer Price Index?
. Basket’ of 500-700 goods & services constructed for the ‘average household’ – but excludes housing costs
. Prices are used to calculate an ‘index’ - from this price inflation can be calculated every month & annually
. Items within basket change over time such as Smart Phone apps added and Sat Navs removed
How has the CPI changed for 2018?
CPIH =
CPI + housing costs (H)
Housing costs include council tax rates & rents paid in the private sector
What are the steps in creating the CPI?
Step 1: survey consumers to determine an average basket of goods
Step 2: find the price of each good in each year
Step 3: calculate the cost of the basket of goods in every year
Step 4: choose a base year & calculate consumer price index taking price changes while keeping quantity the same
Step 5: use the consumer prices index to compute the inflation rate as a percentage change
How is the inflation rate calcuated in the CPI?
((Index in current year - Index in previous year)/Index in previous year ) X 100
Who uses inflation measures?
. Bank of England: Since 1997 the Bank of England has been given a remit to meet a CPI target of 2% (± 1%) per annum-maintained by controlling the money supply
. Wage negotiations: employees interested in real wages & want to maintain their standard of living
. Business contracts, e.g. a construction contract to complete a project over a two-year horizon-to determine correct pricing of projects
Why is the government target for inflation at 2%?
To keep inflation low and stable, helping everyone plan for the future.
What are the main costs of inflation?
. Reduces real income – true since 2008!
. Menu Costs
. Uncertainty
Explain how inflation reduces real income
if you earn £25,000 per annum, then with 4% annual price inflation (& without a wage increase) your real income falls by £1,000 in one year
Explain Menu costs of inflation?
The costs of changing prices you advertise to customers uses up resources, e.g. re-tagging items, implementing new pricing strategies
. When firms incur more costs it is usually passed to consumers =more inflation
Explain the uncertainty costs of inflation
. Bank of England & European Central Bank (ECB) see it as the most important cost of inflation
. Higher inflation tends to be more volatile → future inflation rate is uncertain
. Firms find planning more difficult under inflation because they do not know by much costs increase in the future → investment & employment fall which reduces national income
Why is deflation bad?
. Bad for those with debt
. Consumers delay consumption
. May indicate very weak demand in the economy
Explain why deflation is bad for those with debt?
. Real value of debt increases → bad news for governments with large debts & weak tax revenue
e.g. A debt of £1,000 with -4% price becomes a real debt of £1040 with annual price inflation
. Lenders worry that governments cannot pay interest back on what they have already borrowed – increasing the cost of borrowing for government for future lending
Explain why deflation causes consumers to delay consumption?
Because they anticipate prices to fall → demand falls → prices fall further
Explain why delation potentially signalling weak demand in the economy is bad
Business will pessimistic about the future & postpone expansion plans
What does the aggregate demand curve show? and the slope
Shows by how much national output (GDP) will be demanded at each level of prices.
Negative relationship between AD and price levels
Why does the AD curve slope downwards?
. International substitution effect: consumers switch from domestic goods to imported goods (M above) for a price rise
. Real balance effect: household real savings falls in value, so save more & consume less (C above) for a price rise
What does the Aggregate Supply curve show? and slope
It shows the amount of goods & services that firms are willing to supply at any price level
A positive relationship between AS and price level
Why does the AS supply curve slope upwards?
. short-run: nominal wages are constant
.AS curve slopes upwards because firms find it profitable to expand output when the real wage falls (nominal wages not fully adjusted by the price level)
. firms also increase output because it is profitable to do so compared to their marginal costs (MC)
What is an example of a deflationary period?
Credit crunch led to a demand-led deflationary period
What is demand-pull inflation?
Occurs when a rise in AD leads to an increase in overall prices and shifts the AD curve to the right
What are some examples of demand-pull inflation?
. Reduction in income taxes → increases disposable income
. Increased government spending & improvements in consumer & company confidence
. Reduction in interest rates: increased lending by banks to households & companies
What is cost-push inflation?
When a reduction in supply leads to an increase in overall prices due to rising costs causing AS curve to shift to the left.
What are some examples of causes of cost-push inflation?
. Higher wages: trade unions negotiate real rises in wages
. Depreciation of the exchange rate, e.g. from £1=$2 to £1=$1 increases the cost of imported goods
. The weather, e.g. food costs rise due to a poor growing conditions or floods destroy equipment
What is the BoE Monetary Policy in terms of inflation?
. Bank of England’s Monetary Policy Committee (MPC) will set interest rates every month to meet a 2% CPI inflation target
. The official bank rate is the main policy tool to meet this objective & is set by a committee of nine members
- Governor of the Bank of England, Mark Carney, plus four others from the Bank of England
- four external appointments from business & academia
How does inflation targeting help firms and consumers?
. Price transparancy-helps consumers choose best products easier
. Drives competition between firms lowering prices
. Stable expectations of the economy improves business and consumer confidence
What are the disadvantages of inflation targeting?
. Needs to be semi-flexible in case of a cost-push inflation would require interest rates to rise and GDP to fall further but with future restoration to the inflation target in mind
How does the BoE accommodate for future inflation?
Bank of England’s monthly Inflation Report, November 2018 (published every 3 months) outlines its prediction of future inflation
. e.g. fan chart of the different possibilities or inflation levels till 2021
What is the unemployment rate?
Unemployment rate is the percentage (%) of the economically active over the age of 16 who are available & looking for work (4 weeks) but not currently employed
How is it measured in the UK?
- Unemployment is measured by a survey – an internationally recognized measure
- UK: Office of National Statistics (ONS), Labour Force Survey
Who is excluded from being economically active? and criteria of employment ?
- Employment defined as working one or more hours per week
* Unemployment level: corresponding number of unemployed
What is the unemployment level?
Corresponding number of unemployed
How has unemployment rate changed 1970-2018 in the UK
- Low 70s
- Fell to 70s level before 2008
- Increased after 2008
- now dropped off again after 10 years recovery
Explain the AD for labour and slope
- Aggregate demand for labour, ADL: the number of workers firms wish to employ at the given the wage rate
- Why downward sloping? Labour costs fall as the real wage falls, so firms hire more workers → profitable to expand output & increase number of workers employed
Explain the AS of labour and slope?
- ASL: the number of workers willing to work at the given wage rate
- upward sloping as opportunity cost of being inactive increases with the real wage
What is the definition of classical unemployment?
Refers to when workers have priced themselves out of a job.
Explain classical unemployment
• follows the ‘classical’ approach to economics which argued that markets are always in equilibrium with demand = supply
- unemployment implies aggregate supply of labour > aggregate demand
- Source: trade unions & minimum wage legislation push up real wages above equilibrium
What is the solution to classical unemployment?
• ‘flexibility’ of wage settlements, e.g. fewer public sector workers (traditionally nationally agreed wage levels), non-unionized workforce or limiting strike action over pay
What is the definition of Cyclical (Keynesian) unemployment?
• When workers lose their jobs because of downturns in the business cycle
Explain cyclical unemployment
Keynes ) argued real wages are ‘sticky’ (i.e. not flexible) to move downwards during a downturn in the economy (e.g. in 2008):
- efficiency wages: employers pay above equilibrium wages to keep workers motivated
- wage contracts maintain real wage level
• a reduction in aggregate demand reduces the demand for labour by firms but real wages do not fall so firms let go of workers
What is the solution to cyclical unemployment?
• increase demand for labour, e.g. increase government spending through fiscal policy
BUT not as bad as classical unemployment as once economy recovers unemployment expected to fall again
Why are people not necessarily better off despite record-low unemployment?
Inflation above wage growth so real wages fall= lower standard of living
What types of unemployment are there?
- Classical
- Cyclical
- Frictional
- Structural
What is frictional unemployment?
• When a worker has quit a job and seeking a new one. Only temporary.
What is structural unemployment?
Reflects a dynamic, changing economy where an industry moves into decline and those workers struggle to find new jobs that require different skill set.
What can cause structural unemployment?
- pattern of demand changes, e.g. away from fossil fuels (e.g. coal) towards renewable energy supplies → regional & sectoral unemployment e.g. mining towns
- global competition, e.g. growth of Chinese exports in clothing & steel (effect on UK steel), growth of UK exports in financial services & cars
What is the solution to structural unemployment?
- tax incentives for companies to invest in worker training
- housing policies: affordable housing by encouraging house building e.g. relocation of mining town to find new employment
- improve information about job vacancies
What does the Phillips curve show?
Indicates a trade-off between inflation & unemployment where lower unemployment has to be traded for higher inflation and vice versa.
What does the Phillips curve look like in the Long run?
- Phillips curve is vertical in the long-run → there is no trade-off between inflation & unemployment
- Price expectations are represented by a series of short-run Phillips curves for different rates of price inflation
Explain the Long-run Phillips curve
• workers predict the impact on inflation resulting from fiscal policy & adjust their price expectations accordingly
- workers do not suffer from ‘money or price illusion’, the confusion between nominal & real wages
- Long run GDP is fixed at max/potential GDP
- Still some unemployment-mostly frictional
Explain the process of unemployment readjusting to the long run Phillips curve
- Unemployment falls with inflation
- Workers negotiate higher nominal wage increase
- Firms reduce employment back to natural rate of unemployment
