Inflation in the UK Economy

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...

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...sion (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.

Bibliography

Introductory Economics - GF Stanlake Chapter 11

Principles of Economics ? Lipsey and Chrystal Chapters 26- 32

Macroeconomics ? Greenaway and Shaw

www.tutor2u.net ? inflation, income and unemployment statistics

www.answersleuth.com/numbers/1970.shmtl ? chronology of oil prices

www.thebankofengland.co.uk -The Bank of England ? interest rate statistics