The Bank of England, Types of Inflation - Coursework Example

?Introduction This essay discusses the several types of inflation and the impact created by these types, along with determining and discussing which type of inflation actually creates the most damage to the economy. The term deflation means that the prices of the goods and services in general are on a decline during the financial period. This usually happens when the aggregate demand is less than the aggregate demand and this gap exerts a downward pressure on the inflation rates to such an extent that they actually go in the negative values. Thus it can be said that deflation is the opposite of inflation. The governments and the central banks in all the economies of the world formulate their financial strategies to ensure that the inflation rates do not rise to high levels. However a comparatively more dangerous scenario arises when the inflation rates actually reach negative values, or deflation, because a case of deflation can damage the economy much more than a high inflation rate. Most central banks aim to control the inflation rates to low yet positive rates which are usually at 2-3%, and this is done by keeping the equilibrium point of aggregate demand and aggregate supply at the desired level, as shown in the figure on the right. The same has been the aim of the Bank of England, which is the central bank of England, to keep the inflation rates just above 2% during the financial period. This target has been in the strategy of the Bank of England since the past two years because a positive low inflation rate which is stable and under control is considered the best for the economy. The factors of exactly why deflation is a worse scenario than inflation will be discussed later on in the assignment. Inflation rate is determined by three measures which are Consumer Price Index (CPI), Retail Price Index (RPI) and RPIX. CPI is a measure of the change in the price of consumer goods and services. RPI is calculated by measuring the change in price of all the retail goods and service in the economy. Last is the RPIX which is used in the United Kingdom and is calculated by subtracting mortgage interest payments from RPI. Types of Inflation Inflation is when the general prices of the goods and services in an economy are increasing. Due to the rise in the prices, it has a negative effect on the purchasing power of the money in the economy. Such is because the people can buy a lesser quantity of goods and services with the same amount of money compared to the last year. There are two types of inflation which are anticipated and unanticipated inflation, and both of them create a different impact on the economy. (tutor2u, n.d.) The first type of inflation is anticipated inflation is when the inflation rate can be correctly calculated and the people can protect themselves from its effects. An example of anticipated inflation and protect oneself from it is when the labor union collectively bargains for a wage rise in order to keep the real wages at the same level. They are able to bargain because they are aware of the inflation rate and keep in accordance with it. The second type of inflation is unanticipated inflation. The truth is that the inflation rates can never be predicted to an exact level and the actual interest rate may usually vary to the calculated inflation rate. This variance is called the unanticipated inflation rate, and it exists because the inflation rates are very volatile from year to year and therefore it becomes difficult to correctly predict the rate. Since it is unknown, the people cannot protect themselves from it (Gillespie, 2007, pp. 382-383). An example of this is when a natural disaster such as an earthquake or flood, there is a sudden increase in demand for tents. This situation is showed in the figure above. Inflation is caused by cost push and demand pull factors. Cost push inflation is when the rise in prices occurs due to the rise in prices of the raw materials. When the prices of the raw materials increase, the aggregate supply in the economy decreases and the curve shifts to the left. With the aggregate demand curve unchanged, the equilibrium point changes and the inflation rates rise in the economy. This is shown in the diagram on the right where an inside shift in aggregate supply curve resulted in the rise in inflation rates. Another type of inflation is the demand pull inflation which is caused by an increase in the demand of the goods and services in the economy. This is shown in the diagram on the right where it is shown that due to an increase in the demand in the economy, the aggregate demand curve shifts outside and with the aggregate supply curve unchanged, the changed equilibrium causes the inflation rates to rise. In order to control inflation, it is necessary to control the money supply at the desired level and also to make sure that the aggregate demand and supply do not fluctuate much. (Anderton, 2000, p. 611) Inflation can have a number of disadvantages as well as some advantages, although inflation is generally considered to be damaging for the economy. Inflation can have some advantages over the economy because it is in times of controlled inflation that the businesses experience growth and there is more investment which is very helpful for the economy. Also the stock prices and the value of assets are on a rise during the times of controlled inflation. Such is because there is more investment in the assets in the economy and the stocks which increases the demand of both and results in an increase in their prices (Qwoter, n.d.). The biggest disadvantage of inflation however, is the decreasing purchasing power of money. If an object could be purchased for $1, then it will cost $1.03 for the same object given that the inflation rate in the economy is 3%. (Mankiw, 2011, p. 641) A comparatively more dangerous scenario, than inflation, is stagflation. Stagflation is when the inflation and unemployment rates are on a rise in the economy. This means that the economy as a whole is not improving but the prices are increasing. This has been the case in many of the economies of the world that have experienced simultaneous rise in unemployment and inflation rates. The UK, however, is one of the few economies who have not experienced a case of stagflation. Although the unemployment rate in UK has been on a rise which has reached 8.4% in the last quarter, the inflation rate has decreased to 3.4%. The Bank of England has focused on the monetary policies to keep the inflation rates under control and it has managed successfully to keep it just above its target of 2% (Trading Economics, n.d.). Stagflation can have a major negative impact on the economy because it results in the damage to confidence of the investors and the unemployed people face the added difficulty of decreasing purchasing power of money. Despite the cases of inflation and stagflation, the worst case is when deflation prevails in the economy. As mentioned earlier, deflation is when the general prices of the goods and services in an economy are decreasing. In deflation, the value of money is increasing relative to the other goods and services in the economy. When the supply of goods rises at a rate which is greater than the supply of money, then deflation occurs because the supply usually exceeds the demand which results in a reduction in the prices. The diagram on the right shows a simultaneous increase in the aggregate supply along with a reduction in the aggregate demand in the economy which results in the inflation rates dropping down to P2 and if the same continues to happen, then the inflation rates may eventually drop to negative values which is deflation. Deflation can be caused by two reasons, either by an increase in the supply of goods or a decrease in the supply of money. If the deflation is a result of an increase in the supply of goods and services, then it is good for the economy because it shows signs of economic growth. However, if the deflation is caused by a reduction in the supply of money then it can be a serious problem for the central bank and people. The first cost of deflation is that when the people predict that the prices of goods and services will drop in the future, they curtail their spending so that they purchase something for a lower price in future and get more real value. When they curtail their spending in the present, there is less growth in the economy. This lack in economic growth may actually continue and go on for a longer period, and if it is controlled then it may help to cripple the economy in the long run. The second major cost of deflation is that when the prices in the economy are on a decline, then manufacturers are forced to reduce their prices and this lowers their profit margin. Businesses intend to maximize their profits and a lower profit margin for a longer time will force the businesses to close down. Not only will the current businesses close down, but the future investment will also cease. The third and the last cost of deflation is that a decrease in the prices causes a reduction in the prices of assets and stocks as well. When this happens, then the confidence of the investor decreases which eventually leads to lower investments in the future (Sloman, 2006, p. 583). It is necessary that the money supply is regulated at the appropriate level so that it does not fluctuate too much. Also the government has the option of increasing its expenditure when consumption goes down to ensure that the aggregate demand curve do not shift inwards. Conclusion As discussed earlier, inflation needs to be controlled for good economic growth because low and stable inflation rates lead to stabilization of the economy. This has been the aim of the Bank of England to control the inflation rates at low levels. However, the Bank of England needs to ensure that the inflation rate is kept at a positive figure because if it falls to negative values, or deflation, then it can damage the economy much badly. As discussed earlier, inflation rates usually have short run impacts on the economy but deflation can cause damage to the investors’ confidence in the long run which makes it difficult for the economy to recover in the future, since investment is a key part of the GDP of an economy and also its sustainability. Therefore, deflation is a much more dangerous proposition than the inflation. Bibliography Anderton, A., n.d. Economics. 3rd ed. s.l.:Pearson Education. Gillespie, A., 2007. Foundations of Economics. s.l.:Oxford University Press. Mankiw, G., 2011. Principles of Economics. 6th ed. s.l.:Cengage Learning. Qwoter, n.d. Benefits of Inflation. [Online] Available at: http://www.qwoter.com/college/personal-finance/benefits-of-inflation.html Sloman, J., 2006. Aggregate Supply, Unemployment and Inflation. In: Economics. s.l.:s.n., p. 583. Sloman, J., 2006. Economics. 6th ed. s.l.:Prentice Hall. Trading Economics, n.d. United Kingdom Inflation Rate. [Online] Available at: http://www.tradingeconomics.com/united-kingdom/inflation-cpi tutor2u, n.d. Macroeconomics - Consequences of Inflation. [Online] Available at: http://tutor2u.net/economics/revision-notes/a2-macro-consequences-of-inflation.html Read More