Unanticipated Cost Push and Demand Pull Analysis - Coursework Example

? The Bank of Enlgand's M.P.C. has allowed the C.P.I. inflation rate to stay above its 2% target for more than two years. Discuss the view that deflation is potentially a much worse problem than inflation. Contents Introduction 3 Inflation 3 Deflation 3 Bank of England 3 Main Body 4 Measurement RPI, RPIX, CPI briefly and CPI figure 4 Weighted basket of goods 5 Causes 5 Unanticipated Cost Push and Demand Pull 5 2 short-run diagrams with explanation 6 Benefits of inflation briefly 8 Costs of inflation 8 Compare to costs of deflation 8 Solutions 9 Inflation 9 Deflation 9 Conclusion 10 Reference 11 Introduction Inflation Inflation is defined as the continuous or sustained rise in the general level of price. It can also be defined as continuous reduction in the value of money. The movement in the general price level is referred to as inflation. The rise in the price level must continue over longer period than a day, week or a month (Makinen, 2003, p. 2). Deflation The persistent fall in the average price levels in the economy is defined as deflation. Deflation has been categorized as ‘good’ and ‘bad’ by economists. The former type of deflation arises from improvements in the supply side while the later one arises from the demand side of the economy. Bank of England The new government authorized the bank of England to set the interest rates in 1997. The Bank would act in independent fashion although the target of the inflation was set by the chancellor. The role of price stability in achieving economic stability was soon recognized. Policies to attend targeted inflation rate might cause undesirable volatility in output. A range of inflation rates were set. If the observed rate varied from the lower or upper range by one percentage points, the Bank has to explain the reasons behind such outcome. The proposal of the Bank to drive inflation back on the targeted range should be mentioned in the open letter from the Governor to the Chancellor. But it does not imply that the inflation rate can be anything in the range of 1.0% to 3.0%. The target rate of inflation is 2%. Presently, the Governor has submitted twelve open letters and the Consumer Price Index inflation in all the cases were more than 1% point above the targeted level. The Governor predicted in August, 2011 that inflation will be around 5% in the near future. It is forecasted that inflation will fall in 2012 but the timing or the range of the fall remained unexplained. Main Body Measurement RPI, RPIX, CPI briefly and CPI figure The Office of National Statistics publishes Retail Price Index as a measure of inflation monthly. The RPI of the U.K. is calculated in the following steps. The first step involves selection of a base year around which the price changes can be measured. Then, a list of items required by an average family is drawn up. The relative importance of each item in the family budget is considered with the help of assigned weights. The price of each item listed is multiplied with the assigned weights after adjusting the size of the item according to its importance. The price of each item both in the base and the year under consideration is required. This enables in calculating the percentage change over the desired period of time. PRIX is a measure of inflation which excludes mortgage interest payments. The changes in the price level of goods and services purchased by the households are measured by Consumer Price Index (CPI). The CPI can be calculated as the ratio of updated cost and price of the base period multiplied by 100. For calculating CPI for multiple items the following formula is used: The CPI figure for February, 2012 is 3.4%. Weighted basket of goods The basket of goods refers to the set of consumer products used on yearly basis to catch inflation in a particular market. The goods are weighted by assigning a value to each considering the relative importance in the basket. Causes Some of the causes of inflation are raising costs of imported raw materials, rising costs of labor and high rate of indirect tax imposed by the government. Unanticipated Cost Push and Demand Pull A cost push inflation is a phenomenon where increase in wages and raw materials are the cause of rise in general price level. When production costs rise, the firms react by increasing the prices of the products to maintain the profit margins. This type of situations gives rise to cost push inflation. Cost push inflation is likely to occur when unemployment is falling to low levels. There will be shortage of skilled labor and organizations will have to increase their wage rate to retain the productive employees if they have any intension to expand output. Demand push inflation takes place when there is excess supply in the economy. An excessive growth in the aggregate demand can lead to demand pull inflation. The main causes of increase in aggregate demand are depreciation of the exchange rate, reduction in either direct or indirect or both forms of taxation, rapid growth in the supply of money or monetary stimulus, rise in the consumer’s confidence and faster economic growth experienced in other countries. 2 short-run diagrams with explanation The impact of cost push inflation can be shown by inward shift of the SRAS curve. A fall in the short run aggregate output will cause contraction in the national output. The resultant will be increase in the general price level causing cost push inflation. In a situation of full employment the aggregate supply curve becomes more inelastic. When the aggregate demand shifts the economy still operates at below the capacity level. As there is possibility in expanding output, firms will like to implement a small increase in the price level. The shifting of the aggregate demand curve allows the economy to use full employment of the factors of production. Firms may choose to widen the profit margins. As the demand for goods and services rises, firms will have the capability to increase the price level with the demand remaining unaffected. Benefits of inflation briefly An economy with no inflation is exposed to deflationary pressure. A low rate of inflation helps in the adjustment of relative prices while a moderate rate helps nominal wages to adjust. Inflation also helps in the erosion in the debt value. The costs of expected inflation includes reluctance to hold money, menu costs, greater variability in relative prices, distortions in the way taxes are levied, inconvenience. Costs of inflation The costs of unexpected inflation include arbitrary redistribution of wealth among individuals and impacts on individuals having fixed pensions and bound by fixed contracts. Inflation can shed its effects on the economic efficiency by generating uncertainty in the economy and by distorting the allocation of resources. The governments are under pressure to follow the policies consistent with low inflation as it has already been recognized that high rates of inflation is associated with broader inferior rather than performance of superior quality. Compare to costs of deflation In a situation of deflation consumers can delay the purchases if they expect a fall I the price level. This leads to decrease in the aggregate demand causing prices to go down. Firms have no options but to retrench some workers as they are inclined in cutting down the costs. This also reduces the wage rate. People become reluctant to invest and the value of the debt rises. The Central Bank cannot follow the policy of expansionary fiscal policy and exports become competitive in the foreign market causing a rise in net exports. The preference for low rate of inflation has not shed its effects on the preference for stability in the price level. This reflects the fact of emergence of popular hatred for the deflationary costs. Solutions Inflation Wage and price controls can be taken as the solution to the problems of inflation. The line of thinking assumes that direct controls over wages and the price levels will bring stability in the prices. This may act to nullify the effects of inflation. According to the official of bureaucratic controls such controls can be effective alternatives to less expansive monetary policies. Deflation During deflation, real interest rate is lower than the nominal interest rate. Therefore, central Banks must reduce the rate of nominal interest rates. But the nominal interest rates cannot be dropped below zero percent and the problem of zero-bound problem arises. When such problems arise, government and central banks must inject liquidity into the economy. The liquidity methods will involve fiscal policies rather than the traditional monetary policies. One of the ways to increase liquidity is quantitative easing. It is monetary policy aimed at increasing the money supply by setting aggressive targets for open market operations performed by the central bank. Broad based tax cuts, open market purchases and increase in government expenditure on goods and services are some of the fiscal policies that can be implemented to curb deflation. The Central bank can buy securities directly from the private sector or provide loans to the banks at low rates so that they will lend them to the private sector. Conclusion Inflation and deflation are therefore relative terms. They have direct meaning only in comparison of price levels. A rather complex problem arises when efforts are being made to examine the extent of inflation beyond the forecasted level indicated by the level of prices. In the case of deflation as well it is difficult to decide on whether there is the shortage of credit or the situation is a mere diminution of the aggregate number of units of credit rendered possible by the reduction in prices followed by a reduced demand for credit to carry goods. Reference Makinen, G. 2003. Inflation: causes, Costs, and Current Status.[pdf]. Available at: http://www.policyalmanac.org/economic/archive/inflation.pdf. [Accessed: 29th March, 2012]. Read More