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For hundreds of years before the 20th century the value of the pound had remained almost the same. There where some fluctuations, which where always balanced by the appreciation.
Then during the First World War the pound decreased in its value massively. Although during the recession pound appreciated again, after the 2nd World War depreciation has been remarkable, leaving the pound with a buying power of less than 2% of its value in 1900.
This phenomenon was called inflation and since 1970s the main aim of the conservative government has been to reduce it. To explain how it does this I must first explain the different causes of inflation.
The official measure of the inflation is the increase of the general level of prices measured over a period of time (a year usually), and RPI, TPi or CED is used as a measurement.
First type of inflation is so called cost-push inflation. It basically means that increasing costs of factors of production (wages, rent interest, cost of raw materials, increased normal profit requirement) push up the general level of prices. This applies to the aggregate supply side of the economy and arises partly because general wage costs arise, for example the powerful trade unions might have pushed up wages without increasing the productivity.
Import prices play a role as well, because nowadays no country is independent of the others. When a country has lower inflation than others it tends to "import" inflation with its foreign trade because foreign goods get more expensive. Also, for example, the massive rise in oil prices affected western oil‑importing economies and caused inflation.
The changing exchange rates also cause inflation. It is estimated that a 4% devaluation in a currency raises inflation by 1%.
As the production costs of the firm raise it has to increase its price to cover the costs. Then in turn, as the goods are expensive, labour demands wage increases that will increase the production costs even further.
Especially sensitive to increasing production costs are firms using mark-up pricing as they price their product directly according to the cost plus add a marginal.
Another type of inflation is demand-pull inflation. This occurs when aggregate demand exceeds the value of output (measured in constant prices) at full employment. This is shown in the graph on the next page:
If the expenditure line C+I+G+(X-M) increases (for example due to an expansionary budget), then the new equilibrium shifts from Yfe to Ye leaving an inflationary gap. This is called so, because the economy cannot produce anymore, so the excess expenditure capacity is eliminated by raising the prices. Both Keynesians and monetarists believe that this is associated with an increase in money supply, only Keynesians think that demand brings about the increase in money supply, whereas monetarists think it is the money supply increase that causes the rise in demand.
Third type of inflation is so called monetary inflation. As in the economy MxV=PxT where M is the money supply, V is the velocity, P is the general price level and T is the number of transactions. Now, monetarists believe that V and T are constants, so they thought that money supply and inflation are directly related. This did not imply in 1980 when inflation raised, but money supply remained constant. And indeed the velocity of Mo has increased from 10 in 1970 to 30 in 1990, but the velocity of M4 is much smaller and actually decreased from 1982 to 1987 due to banks making the savings more attractive.
Money supply can rise due to low interest rates (but hight interest might attract hot money), no restrictions on lending or liberate lending policy (especially recently).
In reality the inflation is often multicausal and that is why it is hard to find a real pattern. The chief cause of inflation in one year might not be the same as in the next year.
The consequences of inflation are quite serious. It has bad effect on growth (especially argued by monetarist), because it increases uncertainty and discourages savings. It is also damaging for the balance of payment, because it makes imports cheaper. It distributes incomes in favour of profit earning, away from fixed earning pensioners, whose real income will fall.
There are great controversies regarding the consequences of inflation to the employment. Professor Philips worked before 1965 and invented the Philips curve, showing that inflation and unemployment are inversely related inflation being zero about when unemployment in 5.5%, but latter statistical analyses have not proved its view, indeed it has been argued that more inflation causes more unemployment, or that the inflation affects unemployment only in the short-run whereas in the long run the aggregate supply of labour is perfectly inelastic.
The government has several ways to control inflation. It can do this by means of fiscal policy, that manages the aggregate demand by using government spending.
To reduce inflation government should reduce expenditure and raise taxes. This policy, anyway, works only against demand caused inflation and faces great opposition from the people as they are made worse of by reducing spending on health-care etc. The fiscal policy is very unpopular.
Main weapon to fight against inflation after 1970 has been monetary policy, widely used by Conservatives. The main policies have included controlling interest rates (dear money policy) and medium-term financial strategy (setting guidelines of how much M3 can raise. This system was abolished, because any statistical regularity will tend to collapse once pressure is placed upon it for control purposes (Goodhart's law), so happened to M3 and it grew too rapidly). Also the real inflation is much caused by peoples expatiation on future inflation, reducing the expectations of inflation in the future has been one of the governments' aims.
A very effective way to reduce the cost push inflation is by direct intervention or prices and incomes' policy. This is when government takes measures to restrict the increase in wages (incomes) and prices.
There are two types of direct intervention, like statutory - govn freezes wages and prices and voluntary - government tries through argument and persuasion to make firms adopt smaller prices and wages.
The problems with direct intervention are the confrontation with trade unions and employers, because the prices are much more easily controlled in public sector, it tends to discriminate in favour of private sector. It also distorts market forces, because expanding sectors can't find any new workers, because of the low price, whereas declining sectors hold on to theirs. This policy also tends not to take account the differentials, usually flat base policy is used (e.g. every worker can get a pay rise of £4 a week), which is unfair to people earning higher salaries as their percentage pay rise is much smaller, in the other hand it makes the distribution of income more fair.
Wages' drift will tend to occur, too. The earning will rise faster than wages due to ridiculous bonuses and overtime work (e.g. miners were paid for taking a shower). Usually the normal work-time is reduced and as the workers work the same time they are paid an overtime rate.
Direct intervention policies in the UK have not been used lately. Anyway, in the past they were quite usual. It was first used in 1945 and it was successful till 1950, but collapsed in inflation. Labour and Conservative governments promised not to use it before the election, but then were faced with rising inflation and finally had to. This playing continued for quite a while until in 1980-ies it was agreed that a long-term strategy should be worked out worked out.
Direct intervention policy is more effective in short-term, but it stores up trouble for the future, because prices tend to rise rapidly as soon as the policy is abandoned.