The term inflation is a word that causes a feeling of anxiety in the minds of any population. People begin to think about lifestyle adjustments and decreased savings and this is especially true for the fixed income group. Inflation is an instance where the quantity of goods purchased for a certain sum of money is lower when compared to the quantity purchased with the same amount in the past. A general definition of inflation is “the process of steadily rising prices resulting in the diminishing purchasing power of a given nominal sum of money. Measured by an over-all price index which follows the price changes of a basket of goods and services through time.” (General inflation definition).
This paper analysis steps by which the rate of inflation can be controlled concerning the United Kingdom. Inflation is measured with the help of the Harmonised Index of Consumer Price (HICP), also known as the Consumer Price Index. The value for these indices is obtained through analysis of the cost of certain predetermined commodities and services that are classified under relevant categories and are referred to as the product basket. There are 650 products and about 120,000 prices selected randomly from different markets in the CPI basket in the UK. Once selected these remain constant throughout a particular year. But it is prudent to add or substitute some product or service according to a change in consumer perception or demand. It is also done in instances when a product or service is unrepresented to date. For example, the introduction of the laser disk has virtually replaced the cassette tape and it would be useless to include the price of cassette tapes in calculating the index.
Calculation of CPI
Consumer price index = weighted price of current year x 100/ Weighted price of base year
The purpose of using weighted prices instead of an average price is because not all items in the market are traded at the same rate. It means that the CPI should reflect the average spending pattern on different products and services.
The following table shows the Consumer Price Index and % change covering the years 2000 -2008 in the UK. The percentage change indicating the level of inflation ranges from the low point of 1.4 to the high point of 2.7 in 2007.
Theories of Inflation
Theories on inflation reflect the underlying cause of inflation. So the study of those theories will reveal what are the factors affecting inflation.
The common man believes that inflation is caused by too much demand for too few goods and this is what this theory purports. If the supply of goods meets the demand and there is no surplus, prices will remain the same. On the other hand, if supply cannot keep up with the demand inflation will occur and deflation will occur when supply exceeds demand. Demand may increase because there is more consumer spending, availability of cheap credit, heavy government spending especially on infrastructure, growth in export volume, or a positive expectation of future growth.
AD = Aggregate Demand and AS = Aggregate supply. The Aggregate demand AD1 to AD4 indicates an increase in demand. It can be seen that as and when the aggregate demand increases price level and the GDP also increases. But, in reality, this is just a short-term effect since the country can increase supply by producing more goods or import them from other countries. Aggregate demand is arrived at by the equation AD = C + I + G (X – M), where C is the consumer spending, I is the investment, G is government spending, X is exported and M is imported.
There will be instances when the cost of producing a product or service will rise irrespective of its demand. It could happen when strong labor in the country can demand and get increased wages without a corresponding increase in production. The UK is particularly vulnaralbell to inflation in case of wage increase because it accounts for nearly 66% of the total cost of production. “In the UK changes in wage rates are a significant factor since they account for approximately two-thirds of total costs.” (Grant & Vidler 2008, p.306). The cost of an increase in the price of raw materials is another instance that will lead to an increase in the cost of finished goods.
Again if the country is dependent on imports of finished goods and raw materials, a devaluation of currency can lead to inflation. This increase may encourage local manufacturers to increase their prices which in turn prompt employees to demand higher wages. This situation will only serve to compound an already worsening situation. A rise in profit margins and natural and man-made disasters also contribute to cost-push inflation.
The Quantity Theory of Money (QTM)
This theory states that the price of goods is directly proportional to the volume of money circulating in the market. In other words, it treats money like any other commodity. An increase of money supply into the market results in increased prices. This theory has its origins in 1802 when Henry Thornton found that gold coins introduced into the market in the US caused a rise in prices. This concept was presented in the form of an equation by Irving Fisher, MV = PT, where M is the money supply, V is the velocity of circulation, P is the average price level and T is the total volume of goods and services.
The velocity of money means the number of times it has been used in business transactions. Assuming that there are 100 pounds in the market and that 100 pounds have been used 15 times for different transactions, the velocity of money is 150. “Another way to understand this theory is to recognize that money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency).” (Heakel 2008).
Steps to control the rate of inflation
The best way forward is to find the cause of inflation and remove it. But this is easier said than done since in many cases the cause of inflation may be beyond the control of the government or central bank.
The government implements its monetary policy mainly through interest rates or bank rates, which will determine the cost of borrowing and interest on savings. Monetary policies change according to circumstances and experience and this has been the same in the UK also. A change in interest rates by the central bank will affect the interest rates of commercial banks and other financial institutions. It will also affect the prices of shares and bonds and also the interest on savings. Spending and saving: a higher interest rate will encourage saving and discourage borrowing. Individuals will keep their expenditure low and firms will spend less on business development and investment. This will hurt demand and consequently a fall in the inflation rate. The reverse will happen if the interest rate is reduced.
- Money Supply: According to the quantity theory of money, variation in the price of commodities is affected by the quantity of money circulating in the market. An increase in rates of both borrowing and saving will encourage lower money circulation. People will make more deposits into financial institutions and borrowers forced to spend less money, because of the increased costs of their loans and other borrowings. Again a lower rate of borrowing g and saving will have the opposite effect.
- Prices of assets like property and shares: An increased rate will discourage less borrowing to invest in assets like property and shares. A decreased demand for such assets will help to bring down its prices.
- Effect on exchange rates: A change in interest rates will result in an increased or decreased flow of funds into the UK especially from those countries of the European Union. An increase in rates will encourage foreign funds into the UK resulting in a higher demand for ponds sterling. Such demand will cause the value of the currency to rise and will make imports into the country cheaper. The flow of necessary and cheaper goods will help to offset demand and eventually control the growth of inflation. Exports from the UK will cost more resulting in its earnings coming down. This lowered income will lower demand for the imported goods thereby bringing down the rate of inflation. This also implies that a change in exchange rates for whatever reason will affect inflation levels in a country.
The full impact of changes in interest rates will take about two years even though some changes like consumer spending or saving behavior will be immediate.”But, more generally, a change in the official Bank Rate will take time to influence consumers’ and firms’ behaviour and decisions.” (How do Interest Rates Affect Inflation? 2008).
Even though the monetary policy in the UK has changed, its main of stabilizing prices remains unchanged. Before 1980, the Bank of England had more powers in commercial bank lending policies. After 1980 its aim was focussed more towards the volume of money in the market. But this too was found to be inadequate because controlling the volume of money alone did not have the desired effect on the market.
By the end of the 1980’s the policy was to link the UK monetary policy and inflation with that of other countries. For some time the UK pound was linked to the Deutsche Marks in the ratio of 3:1. In 1990 the country adopted the European Exchange Rate Mechanism (ERM). Monetary policy, but was abandoned in 1992 as a result of the fallout of varying economic conditions across Europe and the unification of Germany.
Ultimately a decision was made to target inflation itself, instead of factors affecting inflation, in determining the interest rate. This policy is now being accepted as the most effective way to curb inflation. The current acceptable level of inflation is fixed at 2.5%. Another significant change occurred in 2003 when UK switched over from the Retail Price index to Harmonised Index of Consumer Prices (HICP), also known as the Consumer Price Index (CPI). It can be seen from the following chart that inflation is limited to or lower than 2.5%. (Inflation. 2008).
The Bank of England had cut interest rates to 4.5% from 4.75 in 2005, which saw the inflation levels rise to 3.1% by 2007. To counter this, the Bank raises rates in August and November 2006, January, May, and July 2007 each time by.25% bringing the rate to 5.75%. it was reduced by.25% in December 2007 and February 2008 to the present level of 5.25%.
Price Controls and Inflation
One of the methods employed in curbing inflation is to fix a ceiling on prices independent of market demand. But price controls would go beyond the principles of a free market economy like the UK. Moreover, it would appear that the disadvantages of price-fixing outweigh its benefits. It has been argued that if a price is regulated for a particular commodity, all factors involved in the manufacture of that commodity like wages and raw materials should also be included in the price control.
Again price control could force many companies in the market to go out of business. “It is no longer the consumers, but the government who decides what should be produced and in what quantity and quality.” (Mises 2005). There is high inflation in the housing sector in the UK and this is an area where not much can be done. The area of land is limited and cannot be increased in proportion to demand.
Further a cut in interest rates will bring down the cost of borrowing but will result in higher demand for land, offsetting the benefit of the interest cut. The rise in international oil prices is a factor that has caused an inflationary tendency, but the government has no role to play in this matter. So price-fixing to curb inflation is at best a short-term policy and is not used extensively. An instance of price control was in 1999 when the UK had announced price controls for water and gas thereby bringing down the cost
Fiscal policy and inflation
Fiscal policies like changes in tax rates and level of government spending can be used to bring down the rate of inflation. Increased government spending says in infrastructure development will result in money inflow into the market. Benefits from such development will take several years to materialize. This will result in a situation whereby there is excess money without corresponding production resulting in inflation. This situation applies more to undeveloped and developing economies because the infrastructure will be poor and huge expenditure will be required. But in a developed economy like the UK infrastructure is well developed such expenditure is unnecessary.
Increasing tax will result in people and companies having less money to spend and this can be implemented to bring down the process in case of inflation. The advantage is that tax rates can be implemented across wide strata of the population (e.g. changes in income tax rates) or on specific areas (taxes on specific products). Another advantage is that, unlike price-fixing, changes in tax rates will not affect the business establishments since the effect of tax in most cases will be passed on to the final consumer.
General inflation definition. London South East Co.Uk. Web.
Grant, Susan & Vidler, Chris., 2008. Cost pull inflation. Economics in Context. Heinamann. P. 306.
HEAKEL, Reem (2008). What is the Quantity Theory of Money? QTM in a nutshell. A Forbes Media Company. Investopedia. Web.
How do Interest Rates affect Inflation? (2008). Interest rates have to be set based on what inflation might be over the coming two years or so. Bank of England. Web.
Inflation. (2008). National statistics. Web.
Mises, Ludwig von., 2005. The Futility of Price Control. Inflation and Price Control.
UK Inflation history. (2008). Money extra.com. Web.