1. THE PROBLEM OF INFLATION
MACRO ECONOMICS
THE PROBLEM OF INFLATION

2. INFLATION
The rate of change of the general price level.

3. The most common way to measure the
inflation rate is to use a Consumer
Price Index/Retail Price Index
The RPI measures the price of a
selection of goods purchased by a
“typical consumer”
The annual percentage change in
the RPI = inflation rate

4. 4

5. Weights are based on information from
the Family Expenditure Survey
e.g. if the RPI = 130 in Jan 2002 and 135
in Jan 2003, the annual rate of inflation
to Jan 2003 is 3.8%

6. The Retail Price Index may overestimate
the actual inflation rate, e.g.
- for an individual living in the north and
mainly buying food and clothes (where
price rises may be limited)
- if a rise in the general price level is
accompanied by an improvement in quality.
Value for money may have increased
- the prices in the RPI may not reflect “special
offers”/discounting on the highstreet 6

7. The Retail Price Index may overestimate
the actual inflation rate, e.g.
- As the general price level rises, people
may switch to cheaper goods outside the
RPI basket (substitution bias)

8. The Retail Price Index may underestimate
the actual inflation rate, e.g.
- for an individual living in the south and
mainly buying services (where price rises
may be substantial)
- A new good may be introduced (e.g. mobile
phones). The good is in demand, rising in
price but excluded from the RPI basket

9. UK Inflation Rate

10. UK INFLATION vs OTHER COUNTRIES
The UK’s inflationary performance
has been mixed. Most of our main
competitors have performed better.
During the 1960s only Japan had a
worse performance than the UK
During the 1970s, 1980s and 1990s
the UK had a worse performance than
our main competitors except for some
EU countries (e.g Italy)

11. UK INFLATION vs OTHER COUNTRIES

12. INFLATION
The Bank of England aims for a
low inflation rate (<2.5%). If the
inflation rate exceeds 3.5% the
Governor is compelled to write to
the Chancellor of the Exchequer
Since the 1970s many Governments
have made keeping inflation low their
number one priority, but WHY?

13. COSTS OF INFLATION
1) Inflation reduces the (real) purchasing
power of money. Money ceases
to be a store of value.

14. COSTS OF INFLATION
The decline in the purchasing power of money can be seen by considering the value of one million pounds. There are currently millionaires in the UK (one for every 500 adults of working age). However it is now much easier to become a millionaire than say in the 1930s. One million pounds could buy much more goods and services in the 1930s than today due to inflation.

15. MILLIONAIRES GALLORE £1 million in 2000 = £1 million at 2000 prices

16. 2) Those on fixed incomes (e.g. pensioners and students) may
COSTS OF INFLATION
2) Those on fixed incomes (e.g.
pensioners and students) may
suffer a loss of purchasing power.
3) Wage claims by workers involve
negotiations e.g BA staff at present
4) Borrowers gain during periods of high
inflation while lenders lose. 16

17. 5) Inflation creates uncertainty possibly
COSTS OF INFLATION
5) Inflation creates uncertainty possibly
harming long-term investment and
growth of national income
Inflation creates menu costs.
7) Inflation can damage a country’s
international competitiveness.
Exports are difficult 17

18. COSTS OF INFLATION
All of the aforementioned costs apply if inflation is unanticipated. However if inflation is anticipated, wages and interest rates can be adjusted so that the real wage and the real interest rate remains unchanged. In the case of anticipated inflation, the costs of inflation are limited to menu costs. 18

19. ANTICIPATED INFLATION
If inflation is perfectly anticipated
Real wages can be held constant
Real interest rates are unchanged
Therefore no real affect on the economy
From this we can see that expectations
are important. Necessary adjustments can be made.

20. CAUSES OF INFLATION
Economists distinguish two causes of inflation.
DEMAND-PULL INFLATION
2. COST PUSH INFLATION

21. DEMAND PULL INFLATION
Demand pull inflation is caused by persistent rises in total spending in the economy 21

22. Inflation caused by persistent rises in the costs of production
COST PUSH INFLATION
Inflation caused by persistent rises in the costs of production 22

23. e.g. Germany, consider the cost of a loaf of bread in Germany…
HYPERINFLATION
Inflation is most costly during periods of hyperinflation (where prices rise at extremely high rates)
e.g. Germany, consider the cost of a loaf of bread in Germany… 23

24. GERMANY’S HYPERINFLATION
Pfennig per loaf
WW1 starts. Germany invades
Belgium and France
Pfennig per loaf
Pfennig per loaf
Hostilities cease on Nov 11
Pfennig per loaf
A harsh peace treaty that includes
heavy demand for reparations on
Germany

25. GERMANY’S HYPERINFLATION
mark per loaf
mark per loaf
mark per loaf
January: 700 mark a loaf
May: 1200 mark a loaf
July: 100,000 mark a loaf
Sept: 2,000,000 mark a loaf
Oct: 670,000,000 mark a loaf

26. GERMANY’S HYPERINFLATION
November 15 a new currency, the
Retenmark was introduced. One new
Retenmark was worth a trillion of the
old marks. Prices are stabilised under
the new currency.
Germany does not hold the world record
for hyperinflation

27. HYPERINFLATION: OTHER EXAMPLES
June Hungary
419,000,000,000,000%
Civil war in former Yugoslavia
1 per 1990 Dinara
= 100,000,000,000,000,000,000 of
the 1994 Dinara.
In Feb 1994 a new currency was
introduced tied 1 to 1 to the German
mark