P. 42 The control of the Inflation, p.648.

Control of inflation has been the chief policy since 1970.

Inflation is an increase in the general level of prices measured over a period of time(a year) by RPI.

Causes

1.      Cost-push inflation-increasing costs of production push up the general level of prices. Supply side.

      Wage costs - powerful trade unions have pushed up wages w/o increases in productivity.

      Import prices - e.g. rise in oil prices, nation can't live w/o inflation if rest of the world does.

      Exchange rates - 4% devaluation rises inflation by 1%.

      Mark-up pricing - makes prices more sensitive to production costs.

      Rent, interest, cost of raw materials

2.      Demand - pull inflation - aggregate demand exceed the value of output (measured in constant prices) at full employment(C+I+J line above I=E). Multiplier.

Keynesian think that demand brings about the increase in money supply, whereas monetarist think it is the money supply increase which causes rise in demand.

3.      Monetary inflation - low interest rates & no lending restrictions too much money available(e.g. gold findings cause).

MxV=PxT where V and T are constants. It was thought that money supply and inflation are related, but this did not imply in 1980 when inflation raised, but money supply fell. Mo has increased from 10 in 1970 to 30 in 1990.

4.         Multicausal inflation - chief cause of inflation in next year might not be the same.

The consequences of inflation.

1.    Bad effect on growth (monetarist), because it increases uncertainty and discourages savings.

2.    For Balance of payment - makes imports cheaper. Relative inflation in other countries matters.

3.    Distributes incomes in favour of profit earning, away from fixed earning pensioners.

4.    Employment - great controversies. Look at Philips curve.

5.    Real value of savings falls(pensioners suffer) and though less investment(also because unsure).

The Philips curve - relates unemployment and inflation

Original curve: inflation and unemployment inversely linked (1962). Infl.5.5%-U=0. The empirical evidence after 1965 shows poor relationship

A relationship exists, but events have moved the curve to right or relationship only in SR. Sherman suggested trend is other way round (stagflation increasing unemployment increases inflation).

The adaptive expectations school

Short term trade off between unemployment and inflation. In the long-run market will return to previous level, but with higher unemployment (Philips curve is vertical in LR).

Nowadays natural rate of unemployment is assumed (after 1970).Pushing it below that results in inflation.

     The money illusion - people become fooled with price changes even if no real change has occurred - in inflation (short-run) offer themselves with lower real wage rates, which increases demand.

Thus AS (aggregate supply) of labour in the short run is normal, but in the long run inelastic.

The Control of Inflation

Fiscal policy (demand management)

Government should reduce expenditure and raise taxes (only against demand inflation)

Monetary policy- through the price and availability of money. Operates after a timelag.

1.     Controlling and increasing interest rates

2.     Medium-term financial strategy

3.     Reducing the expectations of inflation.

4.     Manage money supply

5.     Reduce lending.

Goodhart law - any statistical regularity will tend to collapse once pressure is placed upon it for control purposes.

Direct intervention - prices and incomes policy - govn takes measures to restrict the increase in wages (incomes) and prices. For cost push inflation.

1.     Statutory - govn freezes wages and prices

2.     Voluntary - through argument and persuasion with unions

Problems: 1.            Confrontation - with trade unions e.g.

2.     Discrimination - more effective in the public sector

3.     Distortion of market forces - expanding sectors can't find new workers

4.     Differentials - when flat base policy is used

5.     Wages drift - earning rise faster than wages (bonuses like shorter working time actual-negot.W)

6.     But: Reduces differentials between people in general.

Policies in the UK

First in 1945. Was successful till 1950, but collapsed in inflation. Governments promised not to use, but finally had to. In 1980-ies long-term strategy was worked out.

Effectiveness: successful in short-term, store up trouble in the future.