History, causes and costs of Inflation in the UK economy
Before starting to explain inflation it is necessary first to define it. Inflation can be described as a positive rate of growth in the general price level of goods and services. It is measured as a percentage increase over time in a price index such as the GDP deflator or the Retail Price Index. The RPI is a basket of over six hundred different goods and services, weighted according to the percentage of how much household income they take up. There are two measurements of this: the headline rate (includes all the items in the basket) and the underlying rate (RPIX) which excludes mortgage interest payments. It is the RPIX which is used more often in this country, as a feature of the UK when compared to the rest of Europe is a very high proportion of owner/occupier homeowners. This means that many people have mortgages, and as such, changes in interest rates (to control inflation) can artificially raise the headline rate.
Causes of Inflation
There are two main causes of inflation,
1) Demand Pull Inflation
This is where the total demand for goods and services in the economy exceeds the total supply. This happens after excessive growth in aggregate demand, and creates an inflationary gap. Excess demand in the economy drives up prices, and high prices mean that Suppliers want to produce more units of their product in order to make more money. To supply more, they must increase their production capacity, and the easiest way to do this in the short run is to increase the amount of labour they employ. This means that they are paying more wages, so people will have more disposable income, and hence there is more demand in the economy.
Demand pull inflation is often monetary in origin: when the money supply grows faster than the ability of the economy to supply goods and services. This concept is explained by the Quantity Theory of Money.
The quantity theory of money holds that changes in the general level of prices are directly proportional to changes in the quantity of money. It is obvious though, that merely an increase in the supply would have no effect on prices. The increase must be spent in order for this to happen. This is where velocity of circulation (V) becomes important. If the total amount of all transactions is T, and the total amount of money is M, then
M/T = V
If you add P as the average price level, then you have the Equation of Exchange:
MV = PT
This tells you that, when V is constant, a change in M will lead to a change in P or T, or both. If full employment conditions exist, then an increase in T is not possible in the short run, so an increase in M will result in an increase in P.
If V is variable, an increase in M can be accompanied by an increase in V. This would cause total spending to rise by much more than the increase in M, which is one of the causes of high inflation. When prices begin to rise rapidly, people become reluctant to hold money – they want to exchange it for goods and services as quickly as possible. This can lead to an inflationary spiral, as demand-pull is aggravated as excess demand (and hence prices) again increase.
Monetarists believe that there is a fairly stable relationship between the demand for money and total income (nominal GDP). The demand for income is seen as being determined mainly by the transactions motive (the amount of money people hold for day to day living costs) and for this reason it will be closely related to the level of income.
If you say that the demand for money is a stable function of GDP, it is the same as saying that V is a stable function of GDP. For example, say that at any moment in time, people wish to hold money balances equivalent to 25% of GDP, and that the money supply, is, in fact, equal to 25% GDP. This means that the market for money is in equilibrium. In this situation, V = 4 (V = M/T). Now assume that