Economics | Reference Book 2 The problems
inflation
Inflation Rate = —CP> (n1)~ X100 CPI (n-1)
Thus if we want to know how much prices have increased over last 12 months we would subtract last year’s index from the current indd and divide by last year's number and multiply the result by
100
and all a % sign.Governments are concerned to keep the rate of inflation low for a m; of reasons. Redistribution of income and wealth
Inflation leads to an arbitrary redistribution of income and wealth. Peofk on fixed incomes suffer because their incomes buy less which can h | especially severe on those who retire on a fixed pension, notably tb with independent private pensions. State SSg pensions and some com] pensions are increased to offset inflation. " - “ > Creditors also suffer because the money they receive on repayment bi less than when they lent it. On the other hand, debtors gain. For examf in 1970 in Britain it . ? was possible to buy a modern three bedroom house in Glasgow, Scotland for about *te, £5,000. A person who borrowed £5?0001 on an interest only loan would now have a property worth at least tvvenqr] times that amount and a debt of £5,000. Of course, the person wouli have paid interest over the years and needed to maintain the proper^ but he or she would have had the use of the house for all that time. The lender would be left with a claim to £5,000 and would have received interest on that amount. Inflation can change the nominal value of other physical assets such as land, property in general, jewelry, paintings, etc. At the same time it may push down the real value of financial assets, particularly those with a fixed rate of return such as debentures, and most government securities The real value of bank accounts would also fall unless the rate of interest after tax was greater than the rate of inflation.
Production
A degree of inflation can be helpful to businesses because it builds in an added element of profit. Major supermarket chains have complained that: lower levels of inflation have reduced their profits. Too much inflation, however, can be costly and disruptive. It adds a further element of uncertainty to companies’ plans and makes predicting future costs and revenues difficult. It also makes suppliers very wary of fixed price contracts.
Industrial relations
Inflation and expectations of inflation can lead to pay demands which are themselves inflationary. It can also lead to poor industrial relations and a conflict between workers and employers.
The balance of payments
If a country’s prices rise faster than those of competing countries, export markets will decline and domestic markets will be increasingly penetrated
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by imports which can lead to a deterioration of the balance of payments and a deficit on the current account. If the exchange rate is floating, the country’s currency may fall against other currencies. If the government is trying to maintain a fixed exchange rate, this will be harder to achiev e.
Expectations
Expectations of rising prices can make inflation self-perpetuating. If people expect prices to rise, they will seek higher wages to compensate, which
adds to costs and leads to further price rises. Investors will be reluctant to lend at fixed rates of interest, making it difficult for firms to raise loans. Overseas investors will be less willing to hold the country’s currency for fear that it will fall on foreign exchange markets.
The benefits of inflation
Some people benefit from inflation — those who are able to increase their income in line with, or ahead of, price rises may gain. People with real assets such as their own home will also benefit, but people with financial assets such as bank deposits stand to lose. Those who own shares may benefit because, although shares are financial assets, they represent claims over the physical assets of companies.
Control of inflation
Control of inflation depends on the underlying causes. The cure for demand pull infl ation would depend on what caused collective demand to rise in the first place. A likely cause is government spending more than its income. Governments are always under pressure to increase the range of services provided for the public and have great difficulty in cutting back public expenditure. At the same time, nobody likes paying the taxes needed to finance the public sector. The result may be that the government spends more than it raises in taxes and borrows the difference. The amount the government borrows is known as the Public Sector Borrowing Requirement (PSBR).
Thus the government is putting more demand into the economy through its spending than it is taking out through taxation. The solution is to cut collective demand. The government could cut private sector spending by increasing taxes (not very popular) and cut its own spending by reducing services and benefits (also not popular and difficult to achieve). Increased taxes and lower government spending should reduce the PSBR. Private spending may also be reduced by restricting credit and raising interest rates which should make it more expensive to borrow money and so havean effect on total demand. The problem is that interest rate elasticity of demand may be fairly inelastic, at least as far as consumers are concerned, and so require a fairly high rate of interest to achieve the desired cut in consumer spending. High interest rates may have a much more pronounced effect on company borrowing for new equipment. During the Second World War and for six years after, rationing was used as a way of keeping down demand. While this was accepted during the war, it became increasingly unpopular in the post war years.
Cost push and demand pull inflation may occur together. Rising wages infl ate costs and at the same time add to the spending power of workers.
Economics | Reference I
If they are not matched by a rise in output, demand rises faster i output and prices are bid up (demand pull inflation). Workers then! further wage increases to maintain their living standards adding to < (cost push inflation) and, when they spend, their pay increases, add to demand as well. However, cost push inflation is not the same as deio pull inflation and different solutions are required. With wages for such a large part of total costs, much attention has centered on
h
costs. One approach has been to link pay rises with productivity. Iff wages increase in line with output, pay increases are not inflatioi During the 1960s and 1970s in Britain, governments of both major j used incomes policies to slow down the growth of wages. These tei to be unpopular and met with limited success. In the 1980s and IS the emphasis was on making the labor market more efficient Mone argue that the real solution for inflation is to control the growth ofl money supply.ublic Sector Net Borrowing (PSNB) financing
The impact of the PSNB on money suppiy growth and inflation in 1 economy depends on how it is financed. If the government has a de then the private sector must have a surplus, the bulk of which will
i
up as bank deposits. The PSNB will tend to increase money supply ^ thereby create more inflation in the economy. However, the ult outcome depends on how it is financed. The most appropriate : is to sell an equivalent amount of long-term debt to the non-bank pc sector which prevents any increase in bank deposits or money : taking place)Debt sales by the Treasury include national savings instruments; government stocks (gilts). Unless there is a budget surplus, the Tre knows the estimated PSNB each fiscal year and develops a financ funding programme of debt sales to offset the potential inflatioi impact of the PSNB.
It will sometimes be necessary to adjust the interest rate on new gihsa national savings upwards in order to create sufficient buyers for the i debt in the market. The task is eased by some of the tax privileges ac to public sector debt, such as tax-free national savings certificates. A ] financing policy based on public sector debt sales to the non-bank ] sector reduces the availability of liquid assets in the banking
sp
and curtails its lending capacity. Bank lending creates deposits and i money supply, so PSNB debt sales influence money supply. the economy. Tms is important for controlling the rate or infljAnth inflationary policy
Cost push and demand pull inflation may occur together. The ! encourages workers to seek wage/salary increases to maintain their 1s tandards. This adds to costs in industry and commerce which are lpassed on to consumers in the form of higher prices, i.e. cost push iitfla The latter tends to develop a momentum of its own, with each ^workers asking for income increases to meet higher prices caused by i awards to other groups of employees. Workers also seek awards to ] their relative income position in relation to other crafts and