Urrent recessionary situation in the UK economy - Essay Example

?The objective of this essay is to explain the current recessionary situation in the UK economy. However, in order to perceive the causes, it is first critical to understand what inflation is and what economic dynamics lead to increases in the rate of inflation, i.e., the rate of change in inflation. Broadly, rises in the overall price level of an economy is called inflation. The term stems from the fact that such rises in the price level increase the nominal market value of the real output and thus inflates the nominal GDP. Inflation is typically measured through changes in price level indices of an economy. The most common among these are the Consumer price index and the retail price index. The simplest way to understand the mechanism behind changes to inflation is through Aggregate Demand and Aggregate Supply dynamics. Given the economy is in macroeconomic equilibrium, if there is a positive shock to demand, i.e., aggregate demand shifts up, the price level rises. This is known as demand pull inflation. This type of inflation is observed particularly during periods of economic expansion. This is shown in figure 1 below. Figure 1: Demand-pull inflation In the diagram, SRAD represents the short run dynamics of demand; it shows how changes to aggregate demand are related to changes in the price level or inflation. Similarly, SRAS represents the short run dynamics of aggregate supply. Because of an expansionary shock to short run aggregate demand (SRAD), inflation increases from Is to Id. Again, even if short run demand remains unchanged, inflation can increase due to supply side shocks. For instance if there are bottlenecks in the supply chain which leads to contraction of supply, the short run aggregate supply curve shifts up to the left. This leads to an increase in inflation as well. This is known as cost push inflation since this happens due to sudden increases in production costs. Well known examples of such inflation generating cost rises over the years have been oil price shocks, labor market strikes etc. This mechanism is illustrated in figure 2 below. In Figure 2: Cost push inflation In the graph above, the SRAS curve is hit by a temporary shock resulting from increases in costs. The resulting movement to the left and up leads to a rise in the inflation rate from Is to Ir. It should be noted that all factors that influence demand and supply mechanics can therefore influence inflation rates. Particular note should be taken of inflation expectations. If inflation is expected to rise in future, people start buying immediately and such behavior leads to the prices being pushed up. This is a simple instance of how inflation expectations constitute self fulfilling prophecies. Being armed with an understanding of the basic mechanics of inflation, we now turn to the actual observed situation in the UK economy. The UK economy is undergoing a substantially adverse situation. Although the Bank of England sets 2% as inflation target, the annual percentage change in Consumer Prince Index reached a 2 year high of 5.2% in January 2011. Although it has come down since then to around 4.2% in recent months, it still is considerably higher compared to the declared target of the Bank of England (BBC, 2011). What makes this situation precarious is that this inflation has occurred at a time when the economy was already reeling from a strong recessionary pressure. The global economic crisis and the ensuing recessionary pressures had seem the inflation rate hit a low of almost 1% in 2009. The recession has led to significant stress on the economy and caused losses of employment. In all other advanced economies, the recession has been associated with a disinflation, if not a deflation. In the UK economy however the inflation rate has climbed up substantially to hit the aforementioned highs (Dwyer et al., 2010). There are alternative viewpoints to explain this phenomenon, and we turn to these various explanations in the rest of this article. Figure 3: Inflation in UK, ONS data Figure 1 traces the quarterly movements of RPI and CPI over the span of 2007 – 2011. Although it does not include data for the last one year, the graph does reflect the steady and rapid rise in inflation since 2009. In order to elaborate the reasons behind this rise in inflation it may be useful first, to note the relative contributions of the various components to CPI. This is presented in figure 2. Figure 4: Contributions to CPI; source: BOE The background of the deep recession indeed makes the inflationary spike in recent times quite surprising. During recession, due to continually falling demands, prices usually tend downwards so that overall price rises are moderated. But, it could be seen as an indication of recovery. That is, if an economy is recovering from a deep recession, the aggregate demands start rising. However, such rises typically take time to translate into price level increases since recession leads to piling up of stocks and inventories and unused productive capacities. The rise in prices occurs only when demands have expanded enough to exhaust these capacities. The current situation in the UK does not seem to reflect that this stage of recovery has been achieved (Fisher, 2010). Therefore, given the backdrop of recession, the inflationary tendency reflects economic factors on the supply side that seem to be pushing costs and prices upwards. It has been argued that the current inflation is actually attributable to a series of supply side shocks, namely increase in oil prices, changes to the VAT system and the depreciation of the sterling exchange rate. These shocks have provided temporary upward thrusts to the relative prices. Since oil prices figure directly in the computation of the price indices, sudden increases lead to a rise in the CPI. Additionally, due to the dependence of majority supply chain logistics on fuel, rising oil prices imply rises in production costs as well. This translates into rises in prices of the products. In fact the rise in gas and energy prices which played an important role in terms of contribution to the climb in GDP, The value added taxes are also being transferred onto the consumers through higher prices. Thus, in spite of low demands through changes to the VAT system, increases in prices have occurred. The depreciation of the exchange rate has also led to inflationary pressures. This primarily arises due to the imported intermediate goods becoming relatively more expensive and thus pushing prices up. Additionally, the exchange rate movements lead to import substitutes becoming more popular and thus creating a tendency for higher prices. Finally imported goods are a part of the CPI and thus these exchange rate movements lead to these imports becoming relatively more expensive. However, as argued by Posen (2010), inflation expectations may also have played a significant role in pushing the actual inflation up. He argues that since what really matters for inflation expectations is the actual inflation rate rather than the target set by the Bank of England, and since in recent times the target of 2% has rarely been met, this has fed into the expectations and these movements have led to economic activity which has pushed actual inflation rates further up. Therefore, to conclude, we find that although the recent inflation spike in the UK may seem to be a puzzle given the backdrop of the deep recession, certain shocks to the relative prices have actually led to this phenomenon. Surges in oil prices, changes to the VAT system, depreciation of the exchange rate have all contributed to the rise in inflation. Additionally, the fact that the inflation rate in recent times has rarely met the target may have fed into upward mobility of inflation expectations which in turn has contributed further to the rise. References: BBC (2011) “UK CPI inflation rate rises to 5.2% in September”, Business News, 18th October, http://www.bbc.co.uk/news/business-15344297, accessed on 20th March, 2012. Bank of England (2012) Inflation Report, February 2012, http://www.bankofengland.co.uk/publications/Pages/inflationreport/ir1201.aspx, accessed on 20th March, 2012. Dywer et al (2010) “Inflation and the output gap in the UK”, HM Treasury working paper no. 6, http://www.hm-treasury.gov.uk/d/inflation_output_gap_uk.pdf, accessed on 20th March, 2012. Fisher, P (2010) “Why is CPI Inflation So High?” Bank of England News Release, 29th June, http://www.bankofengland.co.uk/publications/Documents/speeches/2010/speech438.pdf, accessed on March 21st ,2012 Posen, A (2010), “The British recovery in International comparison”, speech at sustaining the recovery Society of Business Economists Annual Conference, http://www.bankofengland.co.uk/publications/Documents/speeches/2010/speech439.pdf, accessed on March 21st, 2012. Read More