ASSIGNMENT 2:

Define Inflation. By using Monetary Policy and Fiscal Policy, how can Inflation be
controlled?

1. What is Inflation?

Inflation is the rate of increase in prices over a given period of time. Inflation is typically
a broad measure, such as the overall increase in prices or the increase in the cost of living
in a country. But it can also be more narrowly calculated for certain goods, such as food,
or for services, such as a haircut, for example. Whatever the context, inflation represents
how much more expensive the relevant set of goods and/or services has become over a
certain period, most commonly a year.

Another definition of inflation is a process of continuous increase in the price of most

goods and services in a country. This does not necessarily mean that all prices increase.
There are some goods, like computers, which have actually dropped in price. Inflation can
therefore be described as persistent general; increase in prices. Inflation is usually given
as the percentage increase in overall prices over a year.

1.1 How do we measure inflation?

Defining a basket of goods and services used by a typical customer and then
keeping track of the cost of the basket, is the measure of inflation. In the twelve
months up to January 2007, the cost of the basket rose by 10% (as an example). This
increase of 10% in the so called consumer price index (CPI) is referred to as
the inflation rate. The CPI is the average spending or living costs of a person.

1.2 What causes inflation?

i) Demand pull inflation

If the economy is at or close to full employment then an increase in AD leads to an

increase in the price level. As firms reach full capacity, they respond by putting up
prices, leading to inflation. Also, near full employment, workers can get higher wages
which increases their spending power.

AD can increase due to an increase in any of its components C+I+G+X-M

We tend to get demand pull inflation, if economic growth is above the long run trend
rate of growth. The long run trend rate of economic growth is the average sustainable
rate of growth and is determined by the growth in productivity.

Example of demand pull inflation in the UK:

In the 1980s, the UK experienced rapid economic growth. The government cut
interest rates and also cut taxes. House prices rose by up to 30% fuelling a positive
wealth effect and a rise in consumer confidence. This increased confidence led to
higher spending, lower saving and an increase in borrowing. However, the rate of
economic growth reached 5% a year well above the UKs long run trend rate of 2.5
%. The result was a rise in inflation as firms could not meet demand. It also led to a
current account deficit.

ii) Cost Push Inflation

If there is an increase in the costs of firms, then firms will pass this on to consumers.
There will be a shift to the left in the AS.

iii) Rising wages

If trades unions can present a common front then they can bargain for higher wages.
Rising wages are a key cause of cost push inflation because wages are the most
significant cost for many firms. (Higher wages may also contribute to rising demand)
iv) Import prices

One third of all goods are imported in the UK. If there is a devaluation then import
prices will become more expensive leading to an increase in inflation. A devaluation /
depreciation means the Pound is worth less, therefore we have to pay more to buy the
same imported goods.

In 2011/12, the UK experienced a rise in cost-push inflation, partly due to the

depreciation in the Pound against the Euro. (also due to higher taxes)

v) Raw Material Prices

The best example is the price of oil, if the oil price increase by 20% then this will
have a significant impact on most goods in the economy and this will lead to cost
push inflation. E.g. in early 2008, there was a spike in the price of oil to over $150
causing a temporary rise in inflation.

vi) Higher taxes

If the government put up taxes, such as VAT and Excise duty, this will lead to higher
prices, and therefore CPI will increase. However, these tax rises are likely to be one-
off increases. There is even a measure of inflation (CPI-CT) which ignores the effect
of temporary tax rises/decreases.
 CPI-CT is less volatile because it ignores the effect of taxes. In 2010, some of the UK
CPI inflation was due to rising taxes.

By using Monetary Policy and Fiscal Policy, how can Inflation be controlled?

Economic policy-makers are said to have two kinds of tools to influence a country's
economy which is fiscal and monetary policy.
Fiscal policy relates to government spending and revenue collection. For example, when
demand is low in the economy, the government can step in and increase its spending to
stimulate demand. Or it can lower taxes to increase disposable income for people as well as
corporations.
Monetary policy relates to the supply of money, which is controlled via factors such
as interest rates and reserve requirements (CRR) for banks. For example, to control high
inflation, policy-makers (usually an independent central bank) can raise interest rates
thereby reducing money supply.

Comparison chart:

Fiscal Policy Monetary Policy

Definition Fiscal policy is the use of Monetary policy is the process by which the
government expenditure and monetary authority of a country controls the
revenue collection to influence the supply of money, often targeting a rate of
economy. interest to attain a set of objectives oriented
towards the growth and stability of the
economy.

Principle Manipulating the level of aggregate Manipulating the supply of money to

demand in the economy to achieve influence outcomes like economic growth,
economic objectives of price inflation, exchange rates with other
stability, full employment, and currencies and unemployment.
economic growth.
 Fiscal Policy Monetary Policy

Policy-maker Government Central Bank

Policy Tools Taxes; amount of government Interest rates; reserve requirements; currency
spending peg; discount window; quantitative easing;
open market operations; signalling

Contents: Fiscal Policy vs Monetary Policy

Policy Tools:

Both fiscal and monetary policy can be either expansionary or contractionary. Policy
measures taken to increase GDP and economic growth are called expansionary.
Measures taken to rein in an "overheated" economy (usually when inflation is too high)
are called contractionary measures.
Fiscal policy

The legislative and executive branches of government control fiscal policy.

Policy-makers use fiscal tools to manipulate demand in the economy. For example:

Taxes: If demand is low, the government can decrease taxes. This increases
disposable income, thereby stimulating demand.
Spending: If inflation is high, the government can reduce its spending thereby
removing itself from competing for resources in the market (both goods and services).
This is a contractionary policy that would lower prices. Conversely, when there is a
recession and aggregate demand is flagging, increased government spending in
infrastructure projects would lead to higher demand and employment.

Both tools affect the fiscal position of the government. For example, the budget deficit
goes up whether the government increases spending or lowers taxes. This deficit is
financed by debt; the government borrows money to cover the shortfall in its budget.
 Monetary policy

Monetary policy is controlled by the Central Bank. But the organization is largely
independent and is free to take any measures to meet its dual mandate: stable prices and
low unemployment.

Examples of monetary policy tools include:

Interest Rates: Interest rate is the cost of borrowing or, essentially, the price of
money. By manipulating interest rates, the central bank can make it easier or harder to
borrow money. When money is cheap, there is more borrowing and more economic
activity. For example, businesses find that projects that are not viable if they have to
borrow money at 5% are viable when the rate is only 2%. Lower rates also disincentives
saving and induce people to spend their money rather than save it because they get so
little return on their savings.
Reserve requirement: Banks are required to hold a certain percentage (cash
reserve ratio, or CRR) of their deposits in reserve in order to ensure that they always
have enough cash to meet withdrawal requests of their depositors. Not all depositors are
likely to withdraw their money simultaneously. So the CRR is usually around 10%,
which means banks are free to lend the remaining 90%. By changing the CRR
requirement for banks, the Fed can control the amount of lending in the economy, and
therefore the money supply.

Currency peg: Weak economies can decide to peg their currency against a stronger
currency. This tool is usually used in cases of runaway inflation when other means to
control it are not working.

Open market operations: The Fed can create money out of thin air and inject it
into the economy by buying government bonds (e.g. treasuries). This raises the level of
government debt, increases the money supply and devalues the currency causing
inflation. However, the resulting inflation supports asset prices such as real estate and
stocks.