Inflation Is the State of an Economy - Essay Example

? Macro & Micro economics: Inflation Introduction Inflation is the of an economy when the general price level in the economy rises due to the falling value of money. This term involves a wide range of variables and does not have any fixed satisfactory definition. In common usage inflation refers to the state of the economy when the money supply is much higher than the physical quantity of goods available in the economy. According to Keynes, inflation refers to that phase of rise in the general price level after the output in the economy grows beyond the full employment level of output (Frisch, 1983). Inflation defined in this way refers to monetary inflation, which is the difference between the growth in money supply and the growth in availability of goods and services in the economy (Siegl, 2009). There are various measures of inflation, but most commonly, inflation is measured by using Consumer Price Index (CPI). The CPI refers to price of a basket of commodities and services that an average customer buys and changes in this index allows economists to study the rise and fall of the general price level in the economy which helps them to study the rate of inflation in the economy. In the latter half of 2012, Bank of England Chief Economist, Spencer Dale, had warned that the average standard of living for the Britons would fall in 2013. The country (UK) is still on the recovery phase from the shock of the financial crisis, this process is a slow and painful one. With a high unemployment rate of 7.8% and wage growth struggling to keep up with inflation, 2013 is looking to be another year of hardship. Causes of inflationary pressure Inflation refers to the upwards movement of the general price level in economy. Prices are determined in the free market economy through the interaction of the sellers and the buyers in the economy. Most economists consider that the inflationary pressure in the economy is caused from either the demand side (demand pull inflation) or the supply side (cost push inflation) pressure on the equilibrium condition in the market (P. J. Welch and G. F. Welch, 2009). Demand pull inflation In long run, when the total output in economy moves towards the full employment output, the economy operates nearly at the full capacity. At full capacity, the economy produces the maximum amount of output by utilizing the available factors of production and the production level cannot be expanded easily. Figure 1: Demand Pull inflation (Source: Pettinger, 2013) At the other end, consumers in the economy are themselves the workers and they are earning more since output level is high at this stage. Hence, there is high consumer demand for services and commodities. This demand pressure from households coupled with the near full capacity production by the producers in the economy triggers inflationary pressure in the economy (P. J. Welch and G. F. Welch, 2009). Cost push inflation Inflationary pressure also occurs when cost to sellers of goods and services rise. Any source of cost to businesses is also a source of increase in rise in prices. Cost to producers and sellers are transferred to buyers partially or wholly and they through rise in prices. Figure 2: Demand Pull inflation (Source: P. J. Welch and G. F. Welch, 2009) Upwards pressure is created on prices if costs of labour, fuel, raw materials and other factors of production rise. At times firms’ attempt to enhance profit in certain industries increases prices and creates inflationary pressure (P. J. Welch and G. F. Welch, 2009). Inflation in UK Between 1989 till present (2013), inflation rate in the UK averages at 2.81%. In May 2013, the inflation rate was 2.70% (Trading Economics, 2013). The inflation rates between 2011 and 2013 is shown in the following figure. Figure 3: Inflation rates in UK 2011-2013 (Source: Trading Economics, 2013) Demand side policies to combat inflation The most important tool to control inflationary pressure in the UK has been monetary policy changes. In the UK, the Bank of England adopts a monetary policy that helps to attain the inflation target set by the government. The rate of interest is altered to achieve the inflation target (that is set at 2%) (Pettinger, 2007). Figure 4: Fall in Aggregate demand due to tight monetary policy (Source: Pettinger, 2007) When the economy gets over heated, inflation rates increase rapidly and it moves beyond the targeted inflation. The Bank of England therefore adopts contractionary monetary policy to reduce the aggregate demand in the economy. Under this policy the rate of interest is increased which slows down the aggregate demand in the economy. In figure 4, aggregate demand curve shifts leftward from AD1 to AD2. Therefore, price level falls from P1 to P2. Since the aggregate demand in the economy falls, the overall consumer spending declines. The effect of this policy can be felt at different stages. These are: At higher rates of interest, cost of borrowing rises; that discourages the consumers from taking loans. Therefore overall spending falls. At higher rates of interest, saving of money becomes more attractive since opportunity cost of holding money rises. Increased rates of interest reduces amount of disposable income for the people making mortgages loans. At higher rates of interest value of exchange rate rises. Therefore exports by UK exporters fall and their import level rises. Supply side policies to combat inflation Supply side policies aim at improving productivity in the economy. The productive potential in the country is raised by taking fiscal policy measures. The government has taken various measures to perk up supply-side performance in UK (Economicsonline, n.d.). Altering the tax system in the economy helps to improve productivity level. Since the economy runs at the full capacity, government takes expansionary fiscal policy to increase output through boosting up the current factors of production. Direct taxes, such as the corporate taxes and the income tax bar, are reduced. This acts as incentive for workers; the unemployed joins the labour force and the existing workers work harder. Lower corporate tax inspires entrepreneurs to start new enterprises and which ultimately increases national output. Measures have also taken to increase labour mobility and flexibility in work conditions, which puts positive effect on productivity. Other labour market rigidities are also reduced, such as power of trade unions is greatly reduced, which has reduced incidents of national strikes and overall productivity in the economy has increased. Besides, the government has made a policy of giving out performance related incentives to government employees that is aimed at boosting up their performance. All these increase the aggregate supply in the economy as indicated by rightward shift of AS curve from AS to AS1 in figure 5. Corresponding price level falls from P to P1. Figure 5: Increase in aggregate supply due to expansionary fiscal policy (Source: Economicsonline, n.d.) The government has also focused on improving firm level performance. There are various measures adopted by the government that can increase competition at the international level and improve efficiency of the firms. As a part of supply side policy, the UK government has provided financial and advisory assistance to the individual firms through encouraging them to implement modern technology in their production process. Reduction of corporate taxes also serves this purpose. Further, product market deregulation lessens barriers to entry and encourages potential entrepreneurs to enter the industry. This promotes healthy competition in the industry and total output from each sector in the economy rises. This is known as competition policy (Economicsonline, n.d.). Evaluation of government policies The policy prescriptions so the government incurs benefits as well as negative side effects on the economy. Both monetary and fiscal policies are efficient enough to reduce the pressure of inflation in the economy. This happens since the consumer spending ultimately comes down while there are productivity gains in the economy. Labour market distortions are also cured through these policy changes. Secondly, positive changes in the market for labour inputs make the growth process sustainable. Increase in competitiveness and productivity allows higher efficient allocation of the resources (Economicsonline, n.d.). Hence the primary objectives of the government, i.e., full employment, stable price level and sustainable growth are fulfilled. While the monetary policy reduces interest rates, increase in actual level of output cannot be realized in the long run. The effect of tax cuts and deregulation of product market also takes time to be implemented. Implementation of certain forms of supply side policies would face strong resistance from different interest groups in the economy. Reforms in the labour market might harm the interest of the trade unions. Efforts to weaken the trade unions might cause tension among the workers and the producers and the government. As an impact of the competition policy, producers might incur lesser profits, which might act as disincentive for entrepreneurs to make higher levels of investment. Thus total economic output might remain unaffected after policy implementation. Finally, these policy changes raise the question of equity. Reduced power of trade unions, lower corporate tax rates positively affects the entrepreneur class. However, tight monetary policy reduces disposable income for the consumers. Therefore, in the short run their benefit falls and a gap might arise between the rich and the poor classes. Reference List Economicsonline, n.d. Supply-side policy. [online] Available at: [Accessed 26 June 2013]. Frisch, H., 1983. Theorie of Inflation. Cambridge: Cambridge University Press. Pettinger, T., 2007. Policies to Reduce Inflation. [online] Available at: [Accessed 26 June 2013]. Pettinger, T., 2013. The wrong and right kind of inflation. [online] Available at: [Accessed 26 June 2013]. Siegl, C., 2009. Inflation - Its Societal and Economic Implications. Munich: GRIN Verlag. Trading Economics, 2013. United Kingdom inflation rate. [online] Available at: [Accessed 26 June 2013]. Welch, P. J. and Welch, G. F., 2009. Economics: Theory and Practice. New Jersey: John Wiley & Sons. Read More