Inflation

Inflation is a general increase in prices and fall in the purchasing value of money, as well as a sustained increase in the cost of living.

The government uses a variety of policies in order to keep a steady inflation. These policies are called demand-side policies and they are used to shift aggregate demand. There are some of the policies.

A monetary policy is the most important tool for maintaining low inflation.  The MPC meet at least once a month to set Bank of England’s interest rate. The inflation target is 2%+/-1 and interest rates are used in order to try and achieve this. To set interest rates, the MPC first have to try and predict future inflation. They try to decide whether the economy is overheating by looking at various economic statistics.

If interest rates fall, they lower the cost of borrowing and the incentive to save up, therefore encouraging consumption. Low interest rates support firms’ borrowing and investment.

Another policy that could be used in order to maintain low inflation is the Fiscal Policy. This policy is similar to the Monetary Policy. It involves the manipulation of government’s spending and taxation in order to affect the level of Aggregate Demand. Lower rates of tax on income would mean that people would have more disposable income and this would therefore boost consumption, causing the AD to shift.

Supply-side policies are actions designed by the government to promote market forces with the aim to increase the productivity and efficiency of the economy. To do this, price flexibility can be increased, which would also increase the competition. In the long run, supply-side policies can help reduce inflationary pressures.

There are two types of inflation: Cost-Push and Demand-Pull.

Cost-push inflation happens when there is a rise in the costs of production and this rise has to be passed on to customer under the form of higher prices.

In the 1970’s Uk Trade Unions pushed for higher wage increases without having a greater productivity level. This lead to the Winter of Discontent in 1978-79 when the level of inflation reached 25%.

In 1973-1974 the supply of oil was restricted by OPEC. This caused massive price increases and a global economic downturn. This action was taken in order to increase oil revenue and income.

Cost-push inflation is still to this day influenced by wage increases, food prices and oil.

Demand-pull inflation – If there is little or no spare capacity in the economy, any increase to the aggregate demand will put prices up.

[pic 1]

Higher interest rates reduce aggregate demand in a variety of ways:

• They discourage borrowing by households and companies

• Increase rate of saving (the OC of spending has increased)

• A rise in mortgage interest expenditures will reduce homeowners' real disposable income and their ability to spend.

• Business investment may also fall, as cost of borrowing will increase. Due to this, planned investment projects would become unprofitable and, aggregate demand would fall.

• Higher interest rates could be used to constraint monetary inflation. A rise in real interest rates should decrease the demand for lending and so decrease the growth of broad money.