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  • Emily Dow

Why so sad @inflation?

Updated: Jan 14, 2021

Firstly, simply, inflation is when there is too much money chasing too few goods. Firms cannot change the scale of their production in the short run, and therefore the only way to counter this is to increase prices (simple supply and demand logic). This, is inflation (the rise in the general level of prices). A central bank's job is to try and control inflation by managing the interest rate (which dictates people's willingness or preference to borrow or save).


Having low and stable inflation is one of the government's main macroeconomic aims, and maintaining inflation at this level (the Bank of England, the UK's central bank classes this as around 2%) indicates that an economy has an efficient use of productive resources, supporting other macroeconomic aims such as economic growth. High inflation (which can turn into hyperinflation and be highly volatile) is undesirable because it causes great uncertainty within a country, as when people borrow they do not know how much they will have to pay back (likewise the lender doesn't know how much they will get back) and therefore this is associated with a lack of long-term borrowing in a country. For example, as of July 2019 Turkey had an inflation rate of 16.65%, and has a low domestic savings rate. The relationship between inflation and other macroeconomic aims are often inverse, however. This is typical with high employment and inflation; in the UK when unemployment is low, wage rates tend to be increasing at a faster rate - a relationship first observed in 1958 by the economist A.W. Phillips - creating the widely studied Phillips curve (in fact, in first and second year Economics at UStA) shown below:


In 2019, UK unemployment reached its lowest rate of 3.8% since 1973, where it hit 3.4%, partially explained by the prospering economy with a steady growth rate of GDP (despite the threats of Brexit) and the increased participation rate of women. Usually, the momentum of a high employment rate would provoke inflation to increase, however inflation in the US has remained steady throughout the past 15 years, despite major economic downturns such as the GFC (Global Financial Crisis). The UK saw similar trends, however inflation has been less stable, ranging from 5.2% in September 2011 and a low of -0.1% in October 2015 between 2010-2020.


These outcomes which defy the fundamentals of the Phillips Curve have elicited deeper research into other causes of low inflation, as it could not solely be explained by the current employment rate and changes in wage rates. One possible explanation is due to the prolonged periods of low inflation created by central banks, expectations of periods of high inflation no longer occur, suppressing things such as the price-wage spiral as expectations are a large part of inflation (nobody will raise prices if they do not expect other to do also). Globalisation (the interconnectedness, cooperation, and coordination of countries and businesses which enhances specialisation, enhancing efficiency and keeping costs and prices low) is another potential cause of the sustained low inflation.


Another suggestion is firms did not react to the GFC by drastically cutting wages and therefore didn't increase wages during the recovery, keeping them relatively stable. This led to a slower, more 'natural' recovery of wages and inflation over a longer period of time, however before wages and inflation were allowed to fully recover, the pandemic started. Despite detrimental impacts on economic growth (through depressed demand and unemployment, among some of the impacts) which has prompted periods of disinflation in the UK (different from deflation, prices are still rising just at a slower rate), the pandemic has prompted greater cooperation between governments and central banks which could assist in increasing inflation. Additionally, government stimulus packages (such as the $2 trillion economic recovery package unanimously approved by the US Senate) provided and maintaining interest rates close to 0% (as of January 4th 2020 the BofE base rate sits at 0.1%) support a higher inflation rate. To increase the chances of the pandemic having a negligible impact on inflation and the overall economy, the BofE have been using quantitative easing increasingly; in November 2020 they had purchased £895 bn worth of government bonds.


In conclusion, although in the midst of the pandemic it does not seem as if inflation is being changed, even helped, by the current economic downturn, however the long-term result of international cooperation and large economic triage packages introduced by governments which will stay in use for years to come (to some extent) could prompt businesses and households to predict future periods of inflation, thus causing inflation. Expectations of inflation are the basis of current inflation, and are therefore necessary if we are to see it change from the plateau-like trend of the past 10 years.


Extra!

In lectures (Intermediate Macroeconomics, University of St Andrews) the investigation of the credibility of the Phillips Curve as a policy tool was discussed. Initially, policymakers thought that unemployment could be reduced by higher inflation (this logic is displayed on the first diagram), however, this was later refuted when policymakers understood that the Phillips Curve was based on inflation expectations deviating from actual inflation, when in fact they are generally quite strong and accurate (particularly if inflation is low and stable, exactly why it is a government aim, and when there is great availability of information). This, in turn, means that it is difficult to use the Phillips Curve as a policy tool because for higher inflation to lead to lower unemployment, our expectations of inflation must always be incorrect. Accurate expectations equate to actual future inflation therefore unemployment will tend towards its natural or structural rate (according to the Phillips Curve), leaving unemployment unchanged and on trend.


Sources used:

Office For National Statistics (ONS) www.ons.gov.uk

Inflation: could covid-19 cause prices to rise? | The Economist https://www.youtube.com/watch?v=8Enam9uNqb4

UK unemployment falls to lowest level since 1975 https://www.bbc.co.uk/news/business-50820280

Determinants of Private Saving in Turkey: an update https://core.ac.uk/download/pdf/6366326.pdf

Bank of England https://www.bankofengland.co.uk/monetary-policy/quantitative-easing

12 Countries with the Highest Inflation Rates in the World https://finance.yahoo.com/news/12-countries-highest-inflation-rates-180545361.html?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAAAg3hx5MwJv3hR09GsYNXAImJtHSL_54LR0c7aLHGhTIHJSutWfF3OQHmLD4IwDSzI87uTp5a_lazZo9rRqKSPG4iY-QsVXqCEGr_W1UnPoiPwPfEZBI4qNCnw7AwCVuexVsq1BUt4I97mI0-K59lB_zDiabiHB7KdKOq9M35e7v

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