Economic Performance (AQA A-Level Economics): Revision Notes

Inflation and Deflation: The Fundamentals

Understanding inflation and deflation

Inflation occurs when the general level of prices in an economy rises persistently over time. Put another way, it represents a continuous decline in the purchasing power of money. When inflation is present, each pound buys fewer goods and services than it did previously.

Deflation represents the opposite scenario. It describes a sustained decrease in the overall price level, or equivalently, a persistent increase in the value of money. During deflationary periods, the purchasing power of money increases over time.

Recent UK inflation experience

The high inflation era (1970s-1980s)

During the 1970s, the UK experienced severe inflationary pressures. Inflation rates were highly variable and accelerating, creating acute economic problems. This crisis elevated inflation control to a top priority for government macroeconomic policy. By 1980, inflation had reached approximately 20%, though it subsequently declined. A brief resurgence occurred in 1990 when inflation touched 10%.

The Great Moderation (1993-2007)

From 1993 to 2007, UK inflation remained remarkably stable. The inflation rate stayed within approximately 1% either side of the government's 2% target, apart from one brief occasion when it exceeded the 3% upper limit. This period coincided with the longest sustained period of economic growth in modern UK history.

In 1997, the government granted operational independence to the Bank of England, allowing it to set interest rates to maintain inflation within the target range. The Monetary Policy Committee (MPC) met monthly (now eight times yearly) to vote on interest rate changes. This independence was viewed as a significant factor in maintaining low inflation.

The 2008 financial crisis and aftermath

The period of stability ended abruptly in 2007. The UK economy was hit by sudden cost-push inflation, largely imported through escalating oil, gas, commodity and food prices. Combined with the credit crunch that began in the USA, this severely undermined business and consumer confidence. The 2008 financial crisis caused aggregate demand to collapse, plunging the UK into its deepest recession since the Second World War.

The sharp but temporary falls in oil, gas and commodity prices were primarily responsible for inflation dipping below zero. Most commentators expected positive inflation to return fairly soon.

Recent inflation trends (2012-2022)

From 2012 onwards, inflation remained close to the 2% target with a margin of approximately 1% either side (ranging from 1% to 3%). A brief rise occurred in late 2017, linked to the sharp depreciation of the exchange rate following the 2016 Brexit referendum.

However, inflation began rising significantly in 2021. During 2022, it reached levels close to 10% - rates not experienced for over 30 years. This high inflation was connected to sharp increases in domestic heating bills, petrol and food prices. Most goods and services experienced unexpectedly large price increases during this period.

Oil prices, which remained elevated in 2022, created knock-on effects beyond petrol costs for motorists. They also increased the cost of transporting raw materials and finished products throughout the country. Supply chain disruptions caused by the Covid-19 pandemic, the war in Ukraine, and possibly Brexit-related issues were all considered contributing factors.

Disinflation versus deflation

These terms are sometimes confused, so careful distinction is important.

The term is applied somewhat loosely to describe reductions in aggregate demand and associated levels of economic activity, output and employment. The phrase 'to deflate the economy' has been used since the Keynesian revolution to describe deliberate demand reduction.

Reflation represents the opposite approach - an increase in economic activity and output. A reflationary policy stimulates aggregate demand. The term 'inflation' is sometimes used to describe 'reflation gone wrong', where policy stimulates the price level rather than real output and employment.

Types of inflation

There are two fundamental causes of inflation: excessive aggregate demand in the economy, and general increases in production costs. These give rise to demand-pull inflation and cost-push inflation respectively.

Demand-pull inflation

Demand-pull inflation (also called demand inflation) occurs when aggregate demand increases beyond the economy's ability to supply goods and services. The cause of inflation originates from the demand side of the economy.

Consider the aggregate demand equation:

$AD = C + I + G + (X - M)$

If the economy initially produces below its normal capacity level (to the left of the LRAS curve), the price level must rise to persuade firms to produce additional output. When production costs increase as firms expand output, they require higher prices to reward the extra production and maintain profit margins. Once the economy reaches the LRAS curve (normal capacity), higher prices may temporarily encourage firms to produce beyond this point, but such increased output cannot be sustained. Eventually, output falls back to normal capacity, though without any fall in prices.

When the economy is already operating at normal capacity (on its LRAS curve), any further rightward shift of aggregate demand results solely in demand-pull inflation in the long run, with no permanent increase in real output.

The diagram also shows why the economy might temporarily produce above normal capacity. At price level $P_1$, firms are only prepared to produce output $y_1$. A higher price level creates conditions encouraging firms to increase output from $y_1$ to $y_N$.

Cost-push inflation

During the Keynesian era of the 1960s and 1970s, inflation rates increased even when little evidence suggested excess demand in the economy. This observation led to development of cost-push inflation theory.

Cost-push inflation (also called cost inflation) locates the cause of inflation in structural and institutional conditions on the supply side of the economy. This particularly relates to the labour market and wage-bargaining processes (known as wage-cost inflation). Rising prices of energy and/or commodities can also cause cost-push inflation (termed import-cost inflation).

Cost-push theories generally argue that monopoly power growth in the economy's labour market and in markets for goods and services is responsible for inflation. During the Keynesian era, growing trade union strength enabled unions to bargain for money wage increases exceeding any rise in labour productivity. Monopoly firms were prepared to pay these wage increases, partly because of disruption costs, and partly because they believed they could pass on increasing costs as price rises when selling output in their markets.

Why correct diagnosis matters

Just as governments must correctly diagnose the causes of unemployment when implementing policies to reduce it, they must also accurately determine whether inflation results from excess demand or cost-push factors. This diagnosis is crucial for deciding appropriate policies to reduce or control inflation.

The Bank of England's approach

In the early 2000s, the Bank of England, responsible for counter-inflation policy, generally assumed UK inflation was caused by excess aggregate demand. The aggregate demand increases occurring in the 1990s and early 2000s were accompanied by an absence of cost-push inflationary pressure. This was partly due to successful supply-side policies implemented during the 1980s and 1990s, which improved labour market flexibility by reducing trade union power. The UK economy also benefited from globalisation's benign effect, which reduced imported manufactured goods prices at that time.

Recent challenges

More recently, the Bank of England has acknowledged that rising import prices are responsible for cost-push inflation. Indeed, cost-push inflationary pressures have become very significant, particularly those stemming from increased energy, oil and other commodity prices such as copper and wheat. Supply chain disruptions caused by Covid-19, Brexit and the war in Ukraine have added to this pressure.

Extension: How inflation theories have evolved

Understanding how economic thinking about inflation has developed helps explain current policy debates.

Historical development of inflation theories

Period	Key Development
Eighteenth century to 1930s	The quantity theory of money dominates economic thinking about inflation
1930s	The problem of inflation disappears. Keynes's General Theory explains deflation in terms of deficient aggregate demand
1940s and 1950s	Keynesians develop Keynes's ideas to explain how, in conditions of full employment, excess demand can pull up the price level through demand-pull inflation
1950s	Early monetarist theory of inflation begins developing when Milton Friedman revives the quantity theory of money (the modern quantity theory)
1950s-1960s	Many Keynesians switch from demand-pull to cost-push theory of inflation
1960s	The Phillips curve is introduced into the Keynesian demand-pull versus cost-push debate
1968	The role of expectations in the inflationary process is incorporated into monetarist theory. The theory of adaptive expectations is built into Milton Friedman's theory of the long-run Phillips curve
1970s	The Phillips curve relationship appears to break down with stagflation's emergence
1980s onwards	Controversy continues between cost-push and demand-pull explanations, with New Keynesian explanations versus monetarist and free-market explanations, the latter incorporating rational expectations into their models
2008 onwards	For a short period the inflation problem largely disappears, being replaced by fear of deflation or falling prices
2015 onwards	Deflation, which had been temporary, gives way to low inflation rates continuing at least until 2019
2021 onwards	Rapidly rising cost-push inflation in late 2021 and 2022 results from rising energy prices (gas and oil), product shortages and increased costs connected with disruption caused by the Covid-19 pandemic, Brexit and war in Ukraine. High inflation means real incomes fall significantly in 2022, resulting in stagflation where prices rise and economic growth rates fall

The monetarist perspective

Around 50 years ago, a group of generally pro-free-market economists became known as monetarists. Monetarist economists subscribe to the demand-pull theory of inflation but argue one stage further: they contend that excess aggregate demand for output is caused by a prior increase in the money supply.

The quantity theory of money

A very old theory originating hundreds of years ago, the quantity theory of money, lies at the heart of monetarist inflation theory. Suppose government creates or allows an expansion of the money supply greater than the increase in real national output. As a result, this extra money, when spent, pulls up the price level - provided real output does not expand in line with increased spending power. At its simplest, the quantity theory is sometimes described as 'too much money chasing too few goods'.

Physical cash in notes and coins forms a relatively small part of total money supply. The starting point for developing the theory is the equation of exchange, devised by American economist Irving Fisher early in the twentieth century:

$MV = PQ$

The velocity of circulation $(V)$ represents the speed at which money circulates around the economy when people use money to buy goods. Monetarists argue that $V$ is constant or at least stable. This means that when $M$ increases, it is spent on goods and services. If $Q$ cannot increase, the price level $P$ is pulled up by excess demand.

Keynesian economists, by contrast, believe that when $M$ increases, it may be partially absorbed by a slowdown in $V$. This means much of the extra money is not spent on consumer goods and services. (However, some extra money might be spent on investment in new capital goods, which would have a beneficial effect on aggregate demand and economic growth, stimulating $Q$ rather than $P$.)

The equation of exchange is often written as $MV = PT$, where $T$ stands for total transactions taking place in the economy. This version was first stated by Irving Fisher. A transaction occurs whenever a good or service is bought and sold. Total transactions include second-hand transactions as well as exchange of new goods and services. Because of this, $PQ$ provides a better measure than $PT$ of expenditure on national output.

Extension: The Keynesian critique

Keynesian economists generally reject the quantity theory of money as an explanation of inflation, or claim it only provides an explanation of rising prices when several highly restrictive assumptions hold.

Three main Keynesian criticisms

1. The velocity of circulation is not constant

Much debate between Keynesians and monetarists about the quantity theory has centred on whether the velocity of circulation of money $(V)$ is constant. In ordinary language, $V$ represents how often money is spent. Monetarists believe that because money earns little or no interest, it is generally rational to spend quickly any extra money holdings, either on goods or on non-money financial assets such as shares, rather than hold idle money balances for any length of time.

By contrast, Keynesians take the opposite view, arguing that under certain circumstances (particularly when share and bond prices are expected to fall), it is perfectly sensible to hold idle money balances. In this situation, to avoid capital losses they expect to suffer from falling financial asset prices, people decide to hold money instead as an idle wealth asset. They hang on to, rather than spend, their extra money holdings.

2. Under-full-employment equilibrium

Keynesians also attack the quantity theory by arguing that if there is spare capacity and unemployment in the economy, an increase in the money supply may increase real income and output $(y$ and $Q)$ rather than the price level $P$. In the Keynesian view, market forces are too weak and take too long to return the economy to its normal capacity output. This means the economy can become stuck in an under-full-employment equilibrium.

3. Reverse causation

The two Keynesian attacks examined so far accept the monetarist argument that changes in $MV$ can cause changes in $PQ$, but they argue that an increase in the money supply $(M)$ does not necessarily result in inflation (an increase in $P$). Instead, an increase in the money supply may be absorbed in a slowing down of the velocity of circulation of money $(V)$, or in a reflation of real income or output.

Keynesians agree with monetarists over what they consider the rather trivial point that an increase in the money supply is needed to finance a higher price level and allow inflation to continue. However, the reverse causation argument rejects the view that an increase in the money supply is the cause of inflation.

The monetarist response is that if the central bank were to exert control over the money supply, a temporary rise in the price level caused by rising costs could not persist. Keynesians argue that if a government tightly restricts money growth to try to stem inflation, the main effect might be that the current level of transactions cannot be financed, so real activity will fall, resulting in higher unemployment. This effect occurred in the credit crunch that started in 2007, though the cause lay not in tight control of the money supply by government, but in a sudden collapse in the supply of money or liquidity emanating from the banking system itself.