Inflation

We need to understand how to measure things like the level of inflation, the level of unemployment, the balance of payments and the size of gross domestic product. Why?

If we are to see how well the economy is doing we need to be able to measure the degree of success.

If we want to know if government should intervene or not – and if so, whether it might wish to expand or to contract the economy.

And, in general terms, we need to understand how we measure so that we know exactly what we are talking about!

We need the information about measurement methods for use when answering exam questions.

Finally, we need to understand how we measure to make sense of the actual models we use later.

THE RETAIL PRICE INDEX

Inflation is an important economic goal and it matters to a lot of people. For such reasons, we have to know how much prices are changing or have already changed, which means that we have to take measurements in some way.

It is clearly impossible to go to each shop in the country and price each item once a month! So we have devised an index to simplify the task. We take a “basket” of goods and services, typical of what people buy, and price these goods and services at a base date. Then we look to see what has happened to the prices of the individual things in the basket since then and tot them up. The government has done this since 1947.

Details: over 600 goods and services go in the basket; once a month we take over
120,000 samples of prices of these 600+ items. This is a bit tricky: the supermarkets, corner shops, 24/7 stores and so forth all have different prices and in addition some areas like London are dearer than others.

Then the statisticians “weight” the items – e.g. housing and transport are more important than salt in people’s budgets, so the important things are weighted more heavily than the unimportant ones. If the price of salt rises by twenty percent it really will not affect us much! But if bus or train fares went up by that percentage it surely would….

If the average rise of all the items, after weighting, is found to have been 0.5% over the month, the government tells us that; it usually also tell us what annual rate of inflation this would represent and how it compares with the same month of the previous year.
At June 2004, the Retail Price Index was up 1.6 per cent over the previous twelve months.

The “RPIX” (which stands for the Retail Price Index Excluding Mortgage Interest Repayments – quite a mouthful!) is a separate measure, which excludes mortgage interest repayments. This is the one that the Monetary Policy Committee focuses on for its policy target, and aims for a rate of 2.5%.

Limitations of the RPI

Not everyone is average, and consumes that exact basket of goods and services, so the RPI does not exactly fit all (but it is close for most!). Pensioners and millionaires obviously have different spending patterns and neither will fit exactly. Pensioners have their own index calculated.

Many goods are “intermediate goods”, e.g., machines to make machines, so these are excluded because they are not “retail”. The underlaying rate of inflation,
which includes the changing prices of everything, can be different from that reported in the RPI.

The basket gets out of date:

o As people change their consumption habits (e.g., there is more foreign travel now than in the 1960s – but rather less after the September 11 New York terrorist bombing).

o New goods and services come onto the market (e.g., DVD players) that were not in the old baskets – so we have to update the basket periodically. This is done each Spring.

o But after we make such a change, strictly we cannot compare the new
price index with the earlier ones, because it covers slightly different goods and services, or we might have altered the weightings used. We still make the comparisons however!

The index does not reflect any quality improvements and these steadily occur.
It is better to think of the RPI as an “estimate” rather than a hard accurate figure. The RPI does not measure the standard of living. It excludes things that have an
important impact on this, such as changes in tax; changes in leisure time; changes

in the physical space available for enjoyment; and changes in the quality of goods and services.

Uses of the Retail Price Index

Unions look at it and may base their wage claims on it.

The government looks at it, to decide if there is a need to intervene and manage the economy (our main interest!).

Journalists look at it, to write articles explaining to people what is happening and their comments and advice might be considered by the government.

Economists look at it, to help them understand what happening and of course to advise others.

Investors look at it, to help decide whether to invest, when to invest, and where to invest.

It is used in international comparisons to evaluate the performance of the UK and compare it with other countries.

It is used to calculate the price rise allowed for some privatised industries that are tightly controlled. These were once state-owned public utilities such as the gas and electricity supply companies. The energy sector is controlled by Ofgem.

The RPI is often used loosely as a measure of inflation – although it only reflects retail prices and indeed not all of those.

What is inflation?

Inflation means persistently rising prices; the term is not normally used by economists (although it may be by the person in the street) for a one-off price rise, for instance if the government increases the level of VAT.

What can cause inflation?

Demand pull = demand exceeds supply at prevailing prices.

Cost push = a shortage of raw materials causes their price to rise; these force up the costs of our producers. Rising import prices can similarly push up our manufacturing costs, as can wage-push inflation.

Hybrid inflation = a mixture of the first two. Either starts the process off, then the other jumps in; they may then alternate in an on-going process.

Government policy can do it, forcing us up the Philips Curve (more later); or the government might increase spending before elections to put more people into work and gain support (this is really a special form of demand pull).

We will investigate the problem through our aggregate supply and demand model later.

Some Problems with inflation

Those on fixed incomes lose out (pensioners, students…). This also changes income distribution.

Those on sticky incomes lose (often public service workers, as it is not easy to increase their wages).

If inflation is too high, it puts entrepreneurs and business people off, so they will not invest as much. Less investment now means slower growth in future.

Benefits of inflation

Moderate inflation can encourage entrepreneurs and business to take risks and invest, leading to a higher growth rate and less unemployment.

We are used to inflation and seem to feel comfortable with it. We are not sure what to do if we face deflation (generally falling prices), e.g., Japan has been stuck in recession since 1990 and also deflating in the last few years. There are signs in 2004 that this may be ending.

Problems with low price rises or even deflation

Low rates of inflation = the situation we are in now (2004).

It may turn into a long-run recession with the danger that we could get stuck, like
Japan.

If this happens, we get low rates of growth, high unemployment and possibly the development of international protectionism and “beggar my neighbour” policies.

When the economy is growing slowly it makes it harder for the government to introduce changes; with fast growth, everything is buoyant, government revenue is up and they can do a lot.

When it is harder for the government to make changes it may mean that downturns in the economy are likely to be more severe and long lasting.

The ability to use monetary policy gets weaker when prices are not increasing much – it is harder to stimulate the economy by reducing interest rates.

Benefits of low price rises

Consumers gain, as goods and services rise little in price.

Fixed income (and sticky income) people gain; groups such as pensioners and students are helped.

A low rate of inflation encourages investment, as people can make a paper profit easily.

Risks are reduced if everyone knows what prices to expect.

 

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