Impact of Inflation in the UK

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1: Abstract

This report will help us to know the relationship between inflation and other parts of economics in the UK. The aim is to provide an explanation for the inverse relationship between economic growth and inflation in this economy in given period. This report will help us to know the types of inflation, why is it important, important dates for UK last 10 years and comparison between RPI/CPI.

2: INTRODUCTION

Inflation is the process of rising prices levels of goods and services which cause an increase in the total consumption to expand, a principle measure of the price of inflation rate is the rate where prices increase over time causing a fall in the purchasing power of the currency (parkin, Mathews and Powell, 2005). According to the economist (John Maynard Keynes), a bit of inflation can grow the economy, the accurate measurement will help distinguish between money values and real values in the economy (Parkin, Matthews and Powell, 2005).

3: Different types of Inflation

Inflation has many types that affect the price level in many different ways, it has been recognisable the prices in the past used to cost and prices of nowadays being increasing on everything such as rent and other living standers (Fernando, 2015).

Main types of inflation (Source: Akrani, 2011)

Main Types of inflation based on rising prices:

  1. Inflation: is the process of rising prices levels of goods and services which cause an increase in the total consumption to expand.
  2. Creeping inflation: this occurs when price level increase over the period in a moderate rate (Indiainfoline, 2017), a small increase in prices over a long period.
  3. Galloping Inflation: this occurs when the prices of goods and services raises at two digits or three digits per year, it also proceeds at an exceptionally high and hard to reduce it, this usually affect people with low wages group, as a result people will have difficulties to save money in the future(Economics Discussion, 2015).
  4. Hyperinflation: occurs when prices increase at a maximum high which become difficult to measure its magnitude (Akrani, 2011), which forces customers to anticipate increasing in inflation, which could occur economic disruption (Hyperinflation, 2009).

Main Types of inflation based on decreasing prices:

  1. Deflation: is the process reducing the price level and decreasing in the output and employment, it’s the opposite of inflation, it usually occurs when there’s recession (Philip’s encyclopedia, 2008).
  2. Disinflation: is a decrease in the rate of inflation.
Summary to all types of inflation (Source: Akrani, 2011), (Moshinsky, 2015)

4: Why is it important?

The data from CPI and RPI rates are used in a lot of ways by the government and business, which will play an important part in the economics, which will help Bank of England uses inflation to set interest rates (BBC News, 2014), it also have some impact on people’s income and wealth.

4.1)  Redistribute of original income

The most common household original income called mode, original income usually includes wages, interest and rent profit earned before paying the taxes, UK is separated into two groups, one is half of the UK had greater income and the other half had less income.

The distribution of income in the UK 2009 (source: Parkin and Blanchard, 2012)

The distribution of disposable income is positive, the mode is (common one) income is less than the median (middle) income, which turns into the mean (average) income.

UK household disposable income last 10 years (source: Office of national statistics, 2017)

4.2: Redistribute wealth

This method measuring economic inequality, a household’s wealth is the value of the things you own, wealth includes the value of money you have in the bank, and also it can be bonds and shares, wealth measures at a point of time (Parkin and Blanchard, 2012)

4.3: Wealth versus income

Wealth is much more unequally distributed than income, which distribution provides a better description of the degree of inequality. Wealth is a stock asset and income is the flow of earning that will result from the stock of wealth (Parkin, Matthews and Powell, 2005).

Example of wealth versus income from (source: Office for National Statistics, 2003)

The cumulative percentage of wealth is graphed against, the cumulative percentage of households. Points A’ to E’ on the Lorenz curve for wealth correspond to the rows of the table. By comparing the Lorenz curves for income and wealth, we can see that wealth is distributed much more unequally than income.

5: Comparison between CPI and RPI:

Two major types that measure inflation which are consumer price index (CPI) and Retail Price Index (RPI) both measures the average of the prices paid by consumers for a fixed basket of consumer goods and services.

Main differences between CPI and RPI (source: Office of national statistics. (2010):

  • CPI = covers certain charges and fees excluded from the RPI such as (University accommodation fee)
  • RPI = covers a range of cost excluded from the CPI such as (mortgage payment, Council tax)
  • CPI includes some financial services not included in the RPI
  • CPI is based on a wider sample of the population for working out weights

5.1: Calculation method (source: Office of national statistics. (2010):

CPI uses a geometric mean (GM), is taking values used in the adjacent example is calculated thus,

An advantage property of the geometric mean is that it can get better changes in people spending patterns relative to changes in the price of goods and services.

RPI is constructed using the arithmetic mean (AM), two different methods, for instance, the AM calculate if one price increased by 25% from the base period which= 100 and another decreased by 20% their new index values would be 125 and 80 the AM of these is:

Issues with measurements (source: (Parkin, Matthews and Powell, 2005) and (TIEN, 2003)):

  1. Substitution bias: this means the composition of market basket changes that will change in relative prices, the consumer will have a substitution for any product the fixed CPI assumes this substitution will not occur.
  2. Quality change bias: to extend equality of goods and services changes year by year, for instance, automobiles tires and mobiles is improving year by year and CPI measurement assumes that these increasing nominal value of the basket is due to inflation rather than quality improvement. 
  3. New goods bias: these days goods keep changes, for example, hard disc is now being replaced by SSD drives, and if you want to compare it with last year SSD much expensive, so the arrival of these goods puts an upward bias into the estimate level price.
The changes in CPI in the UK last years (source: national statistics office)

6: Important dates for UK last 10 years:

Last 10 years UK financial crisis began and causes too many damages for the UK economy and growth and still facing it, and now a historic event for the UK which is Brexit.

6.1: Financial crash era:

Firstly it happened in the subprime mortgage market in the US and then developed into full-blown international banking crisis with collapsing with the investment banks (Williams and Mark, 2010), British banks starts to borrow huge money to fund mortgages for customers, needs to pay off debt by reselling it and the mortgage is international market, and the demand of mortgage has fallen, which causes liquidity crisis (Kingsley, 2012) as shown in the graph when the financial crisis happen in august 2007 the prices of the mortgage has fallen -18.7% tell April 2009 (Kingsley, 2012).

6.1: Post-Financial:

Since the great recession of 2008/2009 UK had the slowest recovery for the economy. After the hit of the financial crash in 2008, UK start to begin recover, unfortunately after three years it hit again via confidence and financial market and trade this the euro-area crisis (Cunliffe, 2016), which lead to the highest level of unemployment in 2012 (Kingsley, 2012), after three years the unemployment fall at the fastest rate and where the growth and productivity began to increase (Cunliffe, 2016).  

Financial crisis mortgage crisis last 10 years (source: Bank of England) 

6.3: Pre- Brexit:

Brexit gonna damage UK economy has been fast and widespread according to (Edwards, 2016), pre- Brexit, UK has been through high record of employment which is 75% and good GDP growth of 2.2% in Q1, that high-water mark already viewed in July and the damage is going wide spread, which made the pound to reflect in the future expected strength of the British economy as shown below in the Graph (Edwards, 2016).

GDP growth and forecast (source: BoE Thomson and Daiwa capital market Europe Ltd).

6.4: Post- Brexit:

After July London property has fallen by 5.6% and prices went down by 0.9% as well rent is going down, before a month of Brexit the prices went up by 0.8%, were declining in prices for properties as decreasing in prices a mark that the money is leaving the market (Edwards, 2016).

Pound versus the dollar (source: ons)

7: Main theories of inflation

Inflation can come from two sides which are demand and the supply side of an economy, it also can arise from internal and external events, a rise in value-added tax could increase in domestic inflation for the short term because firm’s production cost will raise, the unsteadiness in the exchange rate will also can cause inflation (Arooj, 2012), for instance, a decrease in the value of pound against other currencies this could cause increase in the import prices for the items (tutor2u, 2014). Main reasons which cause inflation which are:

7.1. Demand-pull inflation

An inflation that results from an initial increase in aggregate demand (Parkin, Matthews and Powell, 2005), It occurs when aggregate demand is increasing at an unsustainable rate which will cause an increased pressure on scarce resources and a positive output gap (tutor2u, 2014).   

Demand-pull inflation (source: Pettinger, 2014).

Firstly shifting in AD1 to AD2 due to increase in C+I+G+X-M, which makes to get demand-pull inflation when economic growth is above the long- run trend rate of growth. The long run trend rate of economic growth is the average of growth productivity.

Main reasons for the causes demand-pull inflation occur in the UK in the 1980s:

  1. An increase in exports: this is occurring because the rise in prices of imports and decreasing the prices of UK exports, if people buy’s fewer imports, while the export is growing in the UK, AD will increase, and there may be effect on level of demand and output which causes a depreciation of the exchange rate
  2. An increase in government expenditures: this is because UK government in 1980s, there was a very fast increasing in government spending which had caused to get an aggregate demand and rapid economy growing, also they have cut the interest and tax, while increasing the disposable income that causes demand to rise, which led the government to increase spending and increasing borrowing which generates extra demand in the circle flow.
  3. An increase in the money supply: when UK government cuts the interest this has stimulated too much demand, for instance rising demand for loans, which caused the central bank (Bank of England) to print more money.

7.2. Cost-push inflation:

Cost-push inflation occurs when rising prices due to the higher cost of wages of production and higher cost of raw material, it is also determined by supply side factor, which causes a decrease in aggregate supply. (Heakal, 2015).

Cost-push inflation (source: Pettinger, 2014).

A short run aggregate supply shifts to the left, which causes higher price level and lower real GDP.

Main reasons causes’ cost-push inflation:

  1. An increase in money wage rates: wages are one of the main cost facing firms, rising wages will lead to pushing up prices as the firm will have to pay higher costs, that’s mean higher wages will also cause rising in demand (Parkin, Matthews and Powell, 2005).
  2. An increase in the money prices of raw materials: if the prices of the raw material rise, firms decrease in the supply of good and services which will lead a decrease and shift leftward for the aggregate supply (Parkin, Matthews and Powell, 2005).

8: REFERENCES

  1. Parkin, M., Matthews, P.K. and Powell, M. (2005) Economics 6th edition. London: Addison Wesley.
  2. Fernando, J. (2015). Inflation for Dummies. [online] Investopedia. Available at: http://www.investopedia.com/articles/personal-finance/073015/understand-different-types-inflation.asp [Accessed 13 Apr. 2017].
  3. Indiainfoline (2017). What are the different types of Inflation? [online] Available at:http://www.indiainfoline.com/article/news-top-story/what-are-the-different-types-of-inflation-113101402959_1.html [Accessed 13 Apr. 2017].
  4. tutor2u. (2017). Creeping Inflation | Topics | tutor2u Economics. [online] Available at: https://www.tutor2u.net/economics/topics/creeping-inflation [Accessed 13 Apr. 2017].
  5. Akrani, G. (2011). Types of Inflation in Economics With Examples, Diagrams, Graph. [online] Kalyan-city.blogspot.co.uk. Available at: http://kalyan-city.blogspot.co.uk/2011/07/types-of-inflation-in-economics-with.html [Accessed 14 Apr. 2017].
  6. Economics Discussion. (2015). Inflation: Definitions, Kinds, and Causes of Inflation. [online] Available at: http://www.economicsdiscussion.net/inflation/inflation-definitions-kinds-and-causes-of-inflation/4065 [Accessed 14 Apr. 2017].
  7. Hyperinflation. (2009). In: The SAGE Glossary of the Social and Behavioural Sciences, 1st ed. [online] Thousand Oaks: SAGE Publications, Inc., pp.241-242. Available at: http://dx.doi.org/10.4135/9781412972024.n1227 [Accessed 14 Apr. 2017].
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  9. Hugh, C. (2010). The New Encyclopaedia Britannica. 1st ed. London & new york: Encyclopaedia Britannica.
  10. Moshinsky, B. (2015). These maps of the world’s economies will make you forget about China. [online] Business Insider. Available at: http://uk.businessinsider.com/map-of-global-economies-2015-9 [Accessed 16 Apr. 2017].
  11.  Pettinger, T. (2014). Causes of inflation | Economics Help. [online] Economicshelp.org. Available at: http://www.economicshelp.org/macroeconomics/inflation/causes-inflation/ [Accessed 16 Apr. 2017].
  12.  tutor2u. (2014). Inflation – The Main Causes of Inflation | tutor2u Economics. [online] Available at: https://www.tutor2u.net/economics/reference/inflation-causes-of-inflation [Accessed 16 Apr. 2017].
  13. Federal Reserve Board’s semi-annual Monetary Policy Report to the Congress, (2004). New York.
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  15. Heakal, R. (2015). Cost-Push Inflation versus Demand-Pull Inflation. [online] Investopedia. Available at: http://www.investopedia.com/articles/05/012005.asp [Accessed 18 Apr. 2017].
  16. Office of national statistics. (2010). differencescpirpi2_tcm77-229382 | Consumer Price Index | Inflation. [online] Available at: https://www.scribd.com/document/272905743/differencescpirpi2-tcm77-229382 [Accessed 25 Apr. 2017].
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  28. Edwards, J. (2016). The economic damage from Brexit has been fast and widespread. [online]
  29. Business Insider. Available at: http://uk.businessinsider.com/economic-effect-brexit-article-50-reecssion-2016-8 [Accessed 2 May 2017].

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