Inflation means a sustained increase in the aggregate or general price level in an economy. Inflation means there is an increase in the cost of living. What are the economic policies that lead to low inflation in an economy?
1. Monetary Policy
In the UK and US, monetary policy is the most important tool for maintaining low inflation. In the UK, monetary policy is set by the MPC of the Bank of England. They are given an inflation target by the government. This inflation target is 2%+/-1 and the MPC use interest rates to try and achieve this target. The first step is for the MPC to try and predict future inflation. They look at various economic statistics and try to decide whether the economy is overheating. If inflation is forecast to increase above the target, the MPC will increase interest rates. Increased interest rates will help reduce the growth of Aggregate Demand in the economy.
The slower growth will then lead to lower inflation. Higher interest rates reduce consumer spending because: * Increased interest rates increase the cost of borrowing, discouraging consumers from borrowing and spending. * Increased interest rates make it more attractive to save money * Increased interest rates reduce the disposable income of those with mortgages. * Higher interest rates increased the value of the exchange rate leading to lower exports and more imports.
Base Rates and Inflation
Base interest rates were increased in the late 1980s / 1990 to try and control the rise in inflation.
2. Supply Side Policies
Supply side policies aim to increase long term competitiveness and productivity. For example, privatisation and deregulation were hoped to make firms more productive. Therefore, in the long run supply side policies can help reduce inflationary pressures. However, supply side policies work very much in the long term. They cannot be used to reduce sudden increases in the inflation rate.
3. Fiscal Policy
This is another demand side policy, similar in effect to Monetary Policy. Fiscal policy involves the government changing tax and spending levels in order to influence the level of Aggregate Demand. To reduce inflationary pressures the government can increase tax and reduce government spending. This will reduce AD.
4. Exchange Rate Policy
In the late 1980s the UK joined the ERM, as a means to control inflation. It was felt that by keeping the value of the pound high, it would help reduce inflationary pressures. The policy did reduce inflation, but at the cost of a recession. To maintain the value of the £ against the DM, the government had to increase interest rates to 15%. The UK no longer uses this as an inflationary policy.
5. Wage Control
Wage growth is a key factor in determining inflation. If wages increase quickly it will cause high inflation. In the 1970s, there was a brief attempt at wage controls which tried to limit wage growth. However, it was effectively dropped because it was difficult to widely enforce. Main Cause of Inflation
1. 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.
AD can increase due to an increase in any of its components C+I+G+X-M The link between output and inflation suggests that there will be a similar link between inflation and unemployment, The Phillips curve initially showed a link between money wages and unemployment, it was then argued an increase in wages would lead to inflation
2. 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.
Cost push inflation can be caused by many factors
1. The Labour Market
If trades unions can present a common front then they can bargain for higher wages, this will lead to wage inflation. 2. 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 E.G. a German car costs DM 40,000. If the exchange rate is DM £1:3DM then it will be priced at £13,333. If the E.R falls to £1: 2DM then it will be priced at £20,000 3. 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 rise in inflation.
4. Profit Push Inflation
When firms push up prices to get higher rates of inflation. 5. Declining productivity If firms become less productive and allow costs to rise, this invariably leads to higher prices. Source: http://www.economicshelp.org/index.html
PHILIPPINES INFLATION RATE
The inflation rate in Philippines was recorded at 2.90 percent in December of 2012. Inflation Rate in Philippines is reported by the The National Statistics Office (NSO). Historically, from 1958 until 2012, Philippines Inflation Rate averaged 9.1 Percent reaching an all time high of 62.8 Percent in September of 1984 and a record low of -2.1 Percent in January of 1959. In Philippines, the most important categories in the Consumer Price Index are: food and non-alcoholic beverages (39 percent of total weight); housing, water, electricity, gas and other fuels (22 percent) and transport (8 percent). The index also includes health (3 percent), education (3 percent), clothing and footwear (3 percent), communication (2 percent) and recreation and culture (2 percent). Alcoholic beverages, tobacco, furnishing, household equipment, restaurants and other goods and services account for the remaining 15 percent.
This page includes a chart with historical data for Philippines Inflation Rate. Source: http://www.tradingeconomics.com/philippines/inflation-cpi causes
Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation. The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation rests on the quantity equation of money, that relates the money supply, itsvelocity, and the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production. Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run.
Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply relative to the growth of the economy. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates. The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be “long term” in the view of people in an economy.
Keynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices.
Monetarists believe the most significant factor influencing inflation or deflation is how fast the money supply grows or shrinks. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation.] According to the famous monetarist economist Milton Friedman,”Inflation is always and everywhere a monetary phenomenon.” Some monetarists, however, will qualify this by making an exception for very short-term circumstances.
A connection between inflation and unemployment has been drawn since the emergence of large scale unemployment in the 19th century, and connections continue to be drawn today. In Marxian economics, the unemployed serve as a reserve army of labour, which restrain wage inflation. In the 20th century, similar concepts in Keynesian economics include the NAIRU (Non-Accelerating Inflation Rate of Unemployment) and the Phillips curve.
Rational expectations theory
For more details on this topic, see Rational expectations theory. Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well. A core assertion of rational expectations theory is that actors will seek to “head off” central-bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or economic actors will make bets that the central bank will expand the money supply rapidly enough to prevent recession, even at the expense of exacerbating inflation.
Thus, if a central bank has a reputation as being “soft” on inflation, when it announces a new policy of fighting inflation with restrictive monetary growth economic agents will not believe that the policy will persist; their inflationary expectations will remain high, and so will inflation. On the other hand, if the central bank has a reputation of being “tough” on inflation, then such a policy announcement will be believed and inflationary expectations will come down rapidly, thus allowing inflation itself to come down rapidly with minimal economic disruption.
For more details on this topic, see The Austrian view of inflation and monetary inflation The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation. Austrians stress that inflation affects prices in various degree, i.e. that prices rise more sharply in some sectors than in other sectors of the economy. The reason for the disparity is that excess money will be concentrated to certain sectors, such as housing, stocks or health care. Because of this disparity, Austrians argue that the aggregate price level can be very misleading when observing the effects of inflation.
Austrian economists measure inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time. Critics of the Austrian view point out that their preferred alternative to fiat currency intended to prevent inflation, commodity-backed money, is likely to grow in supply at a different rate thaneconomic growth. Thus it has proven to be highly deflationary and destabilizing, including in instances where it has caused and prolonged depressions.
Real bills doctrine
Main article: Real bills doctrine
Within the context of a fixed specie basis for money, one important controversy was between the quantity theory of money and the real bills doctrine (RBD). Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. Currency and banking schools of economics argue the RBD, that banks should also be able to issue currency against bills of trading, which is “real bills” that they buy from merchants. This theory was important in the 19th century in debates between “Banking” and “Currency” schools of monetary soundness, and in the formation of the Federal Reserve. In the wake of the collapse of the international gold standard post 1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as currency boards.
It is generally held in ill repute today, with Frederic Mishkin, a governor of theFederal Reserve going so far as to say it had been “completely discredited.” The debate between currency, or quantity theory, and banking schools in Britain during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence “on the continent”, that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.
Anti-classical or backing theory
Another issue associated with classical political economy is the anti-classical hypothesis of money, or “backing theory”. The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency. Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions. There are very few backing theorists, making quantity theory the dominant theory explaining inflation. ————————————————-
A variety of methods and policies have been used to control inflation.
Stimulating economic growth
If economic growth matches the growth of the money supply, inflation should not occur when all else is equal. A large variety of factors can affect the rate of both. For example, investment inmarket production, infrastructure, education, and preventative health care can all grow an economy in greater amounts than the investment spending.
The U.S. effective federal funds ratecharted over fifty years. Main article: Monetary policy
Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping their inter-bank lending rates at low levels, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum. A low positive inflation is usually targeted, as deflationary conditions are seen as dangerous for the health of the economy. There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches.
For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied. Monetarists emphasize keeping the growth rate of money steady, and using monetary policy to control inflation (increasing interest rates, slowing the rise in the money supply). Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy and fiscal policy (increased taxation or reduced government spending to reduce demand).
Fixed exchange rates
Under a fixed exchange rate currency regime, a country’s currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.
Under the Bretton Woods agreement, most countries around the world had currencies that were fixed to the US dollar. This limited inflation in those countries, but also exposed them to the danger of speculative attacks. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to floating exchange rates. However, in the later part of the 20th century, some countries reverted to a fixed exchange rate as part of an attempt to control inflation. This policy of using a fixed exchange rate to control inflation was used in many countries in South America in the later part of the 20th century (e.g. Argentina (1991–2002), Bolivia, Brazil, and Chile).
The gold standard is a monetary system in which a region’s common media of exchange are paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of specie per currency unit. The currency itself has no innate value, but is accepted by traders because it can be redeemed for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver. The gold standard was partially abandoned via the international adoption of the Bretton Woods System. Under this system all other major currencies were tied at fixed rates to the dollar, which itself was tied to gold at the rate of $35 per ounce.
The Bretton Woods system broke down in 1971, causing most countries to switch to fiat money – money backed only by the laws of the country. According to Lawrence H. White, an F. A. Hayek Professor of Economic History “who values the Austrian tradition”, economies based on the gold standard rarely experience inflation above 2 percent annually. However, historically, the U.S. saw inflation over 2% several times and a higher peak of inflation under the gold standard when compared to inflation after the gold standard. Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output. Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining.
Wage and price controls
Another method attempted in the past have been wage and price controls (“incomes policies”). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. More successful examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in the Netherlands. In general, wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages.
The usual economic analysis is that any product or service that is under-priced is overconsumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term. Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high.
However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed (see creative destruction).
The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many countries, employment contracts, pension benefits, and government entitlements (such as social security) are tied to a cost-of-living index, typically to the consumer price index. A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually in low inflation economies.
During hyperinflation they are adjusted more often. They may also be tied to a cost-of-living index that varies by geographic location if the employee moves. Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments (“COLAs”) or cost-of-living increases because of their similarity to increases tied to externally determined indexes.