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.
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
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
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.
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.
incomes in favour of profit earning, away from fixed earning pensioners.
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
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).
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).
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
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.
and increasing interest rates
the expectations of inflation.
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
- govn freezes wages and prices
- through argument and persuasion with unions
Problems: 1.Confrontation - with trade unions
- more effective in the public sector
market forces - expanding sectors can't find new workers
- when flat base policy is used
5.Wages drift -
earning rise faster than wages (bonuses like shorter working time actual-negot.W)
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.