InflationInflation means a sustained increase in the aggregate or general

price level in an economy, or a fall in the value of money. Inflation means there is an increase in the cost of living.

“inflation means that your money won’t buy as much today as you could yesterday. ”

Why do you think this peak was followed by this crash?

What happened here?

What do we know about the causes of inflation in the 1970s?

What caused this ‘mini peak’ in the late 80s?

What happened in 1997?

What is the difference between the RPI and CPI measure?

What was the inflation target during this period?

Why did inflation rise steeply in 2008?

Why did the RPI measure fall so rapidly?

1994-2006 The NICE era (non-inflationary, consistently expansionary period).

During this period the UK economy experienced sustained growth, low unemployment and controlled inflation. This period is also known as the Great Moderation.

Check Point

Inflation is an unavoidable feature of the UK economy and governments should spend less time worrying about it.

Discuss

The causes of inflationAt AS we learnt that excess demand can lead to inflation. This is known as demand-pull inflation.

Does increasing demand always lead to higher prices?

We also learnt that increasing costs can cause firms to raise prices. This is known as cost-push inflation.

Which costs are most significant to a firm?

Which periods in UK economic history are examples of demand-pull and cost-push inflation?

Developing your understanding…At A2 we learn that theories about what causes deflation have changed

over time.

• Until the 1930s, the quantity theory of money was dominant• Keynes developed the idea that demand only caused inflation to rise

when the economy was in a position of full employment• Monetarist theory begins to develop in the 1950s – the new quantity

theory of money• In the 1960s, some Keynesians developed cost-push theories of inflation• The Phillips Curve was developed to inform the demand-pull/cost-push

debate• Monetarists criticised the Phillips Curve theory and came up with a long-

run version of this theory

The quantity theory of money…

… states that inflation is caused by an increase in the money supply.

… “Too much money chasing too few goods”… a demand-pull theory of inflation

How does an increase in the stock of money cause prices to increase?

The Fisher equation of exchange helps us to understand the quantity theory of money.

There are two ways of thinking about the money in the economy:

1. The monetary systemWe can think about an abstract idea of the stock of money and the velocity of circulation. The circular flow model (above) helps us picture money circulating around the economy. If we multiply the stock of money by the speed it circulates we can calculate the economic activity over a period of time.

2. The real economyWe can think about the actual transactions (i.e. the number of purchases made) and the average price of these transactions. If we multiply these together we should get the same value as in No. 1.

Money supply x velocity of = price level x total transactions(stock of money) circulation of money

MV = PT

How does this help us understand inflation?

The quantity theory of money states that an increase in the stock of money will increase the price level.

MV = PTFor this to be true:• The velocity of circulation and number of transactions

(determined by the level of real national output) in a given period must both be fixed, or at least stable

• Any money people receive is quickly spent (i.e. it is a medium of exchange and not a store of value)

• The change in price is assumed to be as a result of a change in the stock of money, not the other way round

Here’s how it might look in practice…

1. The Bank of England condones an expansion of the money supply, perhaps through quantitative easing.

2. Firms’ output does not rise sufficiently to give something for people to spend their money on.

3. Households can’t find enough goods to spend their money on. Firms inflate their prices to absorb this excess money.

Too much money chasing too few goods.

MV = PT

Check Point

Explain two reasons why an increase in the stock of money in the economy may not lead to inflation.

What would Keynes say?People may prefer to hold their money rather than immediately

spend it, particularly when asset prices are expected to fall.

If there is unemployment in the economy then firms may respond to

increased demand by increasing output rather than prices.

More fundamentally, what if it is an increase in prices, caused by cost pressures, that causes households to pull more money in to the system? This would mean that inflation

causes an increase in the money supply, rather than the other way round.

Keynes’ insights reveal that the old quantity theory of money is too simplistic. The relationship between the money supply and inflation is complex and not one-way. Keynes also warned that restricting the money supply could in fact lead to a fall in transactions which would depress the economy… this happened in the 2007 credit crunch.

You can see from the Keynesian AD/AS diagram that where the spare capacity exists, Keynes argued an expansion of demand would not cause inflation. However, Keynes did accept that increasing AD when the economy was near full capacity would cause inflation. However, rather than increases in the money supply, Keynes pointed to real factors, like government spending which injects actual cash in to the economy, as causing the inflation.

Both the quantity theory of money and Keynesian theory agreed on the following:• Governments were the cause of inflation (whether due to increasing money

supply or spending too much)• Inflation was due to excess demand in the economy

The Keynesian demand-pull theory of inflation asserts that excess demand will cause prices to rise where the economy is near to full capacity. However, the reasons for this increasing demand are different from those in the quantity theory of money.

Twitter BickerImagine an argument on Twitter between Keynes and an economist from the old-school of quantity theory. How would the argument progress?

Monetarists @quantitytheoryThe government must limit the supply of money

to bring down this high level of inflation.

Keynes @keynesiansRus

Monetarists @quantitytheory

Keynes @keynesiansRus

Monetarists @quantitytheory

Keynes @keynesiansRus

The Keynesian cost-push theory of inflation states that factors which increase the cost of production across the economy may lead to increased prices.

During the 1950s – 1970s, inflation persisted despite there being no apparent excess demand in the economy. Keynesians identified rising costs for firms as the cause of inflation:• Wage costs• Imported materials• Essential commodities

e.g. oil

These cost pressures were a particular problem in the 1970s when oil prices spiked and trade unions pushed for wage rises.

Ingredients for 1970s Inflation Pie

1. An excess of monopoly power2. Strong and militant trade unions3. A tendency to cost-plus pricing4. One full-employment objective by government5. Plenty of labour protection legislation and

welfare benefits6. A large portion of oil (warning: increasingly

expensive)

Policy?a) Increase IRb) Expansionary

fiscal policyc) Supply-side policy

Can low inflation and low unemployment be achieved?Wage rates are more likely to rise when there is low unemployment as firms compete to employ scarce workers. Equally, when unemployment is high workers are unlikely to demand higher wages as they fear for their jobs.

To what extent does the graph on the left support the link between wage growth and the level of unemployment?

If wage increases lead to inflation, what can we conclude about the link between unemployment and inflation?

This data is that used by A. W. Phillips when he investigated the link between wages and unemployment.

The Phillips Curve Phillips used 100 years of data to analyse

the link between unemployment and the wage level

Plotting these, he found that there was an inverse relationship between the two i.e. wage levels rose as unemployment fell

Later versions of the curve linked unemployment to price level in the same way

The model supports both Keynesian theories. Lower unemployment may be associated with increasing AD therefore demand-pull inflation, or be the basis for higher wage demands therefore supporting cost-push theory

The model appears to suggest that government must prioritise either inflation or full employment.

Does Phillips’ evidence support Keynesian demand-pull or cost-push theory of inflation?

Examining the evidenceTo what extent does the above US data support the idea of a trade-off between inflation and unemployment?

Between 1979 and 1983, inflation falls and this is followed by an increase in unemployment.

Between 2007 and 2010 inflation unemployment rises rapidly at the same time as a fall in prices.

What triggered the 1979 trade-off?

What triggered the 2007 trade-off?

Complete these cause and effect chains which demonstrate the demand-pull and cost-push arguments about the trade-off between unemployment and inflation.

Interest rates fall

Aggregate demand…

Unemployment falls because…

Wages, and therefore inflation, increase because…

Cost of living increases

Trade unions protect jobs and push up….

Firms are unable to lay off workers because…

Inflation rises because…

MONETARISTSTRIKES BACK

THE

The fight back against Keynesianism came in three waves:

The revival of the quantity theory of money by Milton Friedman in 1956

The development by Friedman of the expectations-augmented Phillips curve

The incorporation of rational expectations theory

In the 1970s, stagflation appeared to disprove the idea that inflation only occurred at low levels of unemployment. According to the diagram below, has the Phillips relationship broken down in the 1970s?

Friedman argued that the Phillips relationship was a short-term phenomenon. In the long term, there is a natural rate of unemployment (NRU). Free market economists argue that if unemployment is forced below this level then inflation will occur. This will turn into hyper-inflation as workers bid up wages increasingly as they expect inflation to keep rising.

Assumptions• People form expectations of

future inflation on the basis of current inflation

• They will demand wage rises in response to expected inflation

• Therefore the wage rate will increase in line with the rate of inflation

• Point A is the starting point where unemployment is at its natural rate, inflation is zero and the expectation of future inflation is zero

Unemployment rate

Inflation rate

LRPC

SRPC1UN

P1

A

1. Gov increases AD (A to B) therefore increased demand for labour

2. Wage rise needed to attract workers into the labour market which causes inflation (P1)

3. Workers suffer money illusion as they believe this is a real wage rise and enter the labour market

4. Firms also suffer money illusion as they believe increased revenue will more than cover labour costs

5. Now expecting inflation, workers bid up their wages further causing the SRPC to shift rightwards (B to C)

6. Increased wages increase AD and the cycle continues

As hyperinflation takes hold, the economy breaks down and the NRU increases leading to stagflation.

The solution is for the government to bring down expectations of inflation.

How is the monetarists expectations-augmented Phillips curve related to the AD/AS diagram below?

A

B

C

D

E

1. According to neo-monetarists, does the Phillips curve relationship exist?

2. What is the natural rate of unemployment?3. Why is it inflationary to push unemployment below

the natural rate?4. What role do expectations play in this theory?

The psychology of inflationSam expects inflation to carry on at the same rate as it is now. He suffers from money illusion.

Julie keeps up with the news and knows inflation is expected to rise further. She behaves rationally and does not suffer from money illusion.

Adaptive expectations

Rational expectations

Friedman thought people behaved like Sam. They would be drawn in to the labour market by higher wages and not understand that higher inflation in the future would erode their real wage. According to Friedman, there would therefore need to be a period of higher unemployment to ‘bleed’ the system of expectations of inflation.

New-classical economists think people are like Julie. They are not fooled by nominal wage increases. Therefore, increasing aggregate demand will not result in unemployment levels falling below the natural rate; there will just be inflation. This leads to the conclusion that, as long as people believe government will take a tough stance on inflation,. expectations will be rapidly brought under control without a purging period of unemployment

Inflation psychology today…What are the rational expectations of people now?How confident are we that inflation is under control?

If we expect higher inflation, why aren’t we pushing up wages?

Inflation is higher and unemployment has fallen, as the Phillips curve would predict.

However, demand is low and real wages are falling. What explains the inflation and the improved employment?

Essay

Part AExplain the possible causes of inflation. (15 marks)

Part BSince the ‘credit crunch’ which started in 2007, and the subsequent recessions, the Bank of England have rapidly decreased interest rates and embarked on a programme of quantitative easing. Government have also injected considerable amounts into the economy through public spending. During this period the prices of imported food and oil have risen, and real incomes have fallen.

Discuss whether the inflation experienced during this period may be the result of monetary influences as opposed to ‘real’ factors, such as cost pressures and government spending. (25 marks)

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