The UK economy was once characetrised by high inflation, which affected the economic stability of the country (Bank of England, 2004). Inflation is defined as the change in consumer prices index (CPI) from the exact period the previous year. The CPI on the other hand is defined as a measure used by governments to measure the change in prices of specific goods and services. Some of the products and services included in CPI measurements include cost of transportation, food, electricity and housing among others.
In the 1970s, inflation was at an average of 13 percent a year and reached its peak in 1975 when it hit the 27 percent mark. In the 1980s, the prices were fairly stable and inflation was at an average of 7 percent a year. Though this is not the case anymore, the country is yet to come up with a macroeconomic policy that will ensure that prices remain stable within set inflation targets.
According to the bank, the target inflation is 2.0 percent, while the prevailing rate is at 3.0 percent. In February 2010, inflation rose to 3.5 percent and the Bank of England explained that government’s action to restore value added tax to 17.5 percent influenced and led to an increase in inflation. The government had reduced VAT to 15 percent in a bid to encourage consumer spending during the 2008-2009 recession.
Causes of inflation
According to the Bank of England (2004), inflation occurs when the demand exceeds the ability by the economy’s capacity to produce goods and services. When this is the case, the prices rise in response to the increasing demand. With an increase in the supply of money, this automatically leads to inflation. According to Sloman (2007), excess demand in goods and services leads to demand-pull inflation.
The main causes of demand-pull inflation in the UK includes: 1) depreciation of the sterling pound’s exchange rate; 2)reduction in taxation, therefore allowing consumers to have more money to spend;3)increased liquidity in the market especially when banks increase their lending to people and institutions; 4)a rise in consumer confidence especially in the real estate industry; 5) increase of asset prices ; and 6) economic growth in UK trading partner economies thus providing a ready market to the UK exports.
A different kind of inflation is the cost-push inflation (Sloman, 2007). Such is caused by external shock to the UK economy, such as fluctuations in commodity prices; depreciation of the sterling pound exchange rate; and /or the increase of unit labour costs or wages. When cost-push inflation occurs, firms usually respond by raising prices for goods and services in order to protect their bottom lines.
Effects of inflation
One of the most notable consequences of inflation is that money loses value (Sloman, 2007). As a result, people no longer have as much confidence in their currency, and usually this leads to a reduction in savings as people opt to invest in assets hoping that such will give them real value.
As one would expect, when the prices of goods and services increase, people have to find a way of maintaining their living standards. Usually, this leads to wage increase demands. Employees who cannot bargain wage increases usually end up living in poorer conditions, or working extra jobs in order to survive the inflation.
Unlike savers who are usually on the receiving end of the inflation when their savings loose value, inflation tends to favour people who borrow money since it erodes the value of their debts. This then means that inflation is less equitable and unsustainable. Economic analysts argue that a market economy such as the UK cannot survive a process where wealth is arbitrary allocated to the borrowers due to inflation effects, while the savers and people with fixed incomes loose out.
The Bank of England (2004) states that inflation increased the risks associated with borrowing and saving. This then calls for some form of insurance against the uncertainties that money may loose value. The risk premium usually results in higher interests’ rates, which drives the costs associated with borrowing higher and eventually, the high borrowing costs discourage investments.
According to Sloman (2007), inflation can further lead to disruption of business planning thus leading to lower investments in the long-term. It is also touted as one of the leading causes of unemployment because as employers try to keep up with the higher wage demands, they lay off some of the staff members. More to this, inflation makes it hard for business expansion thus meaning that employers cannot recruit at a high rate.
Inflation also leads to reduced global competitiveness because the basic measures of production, most specifically labour is costly. This then means that the overall price of products and service are high compared to those produced where inflation is lower. Financial institutions usually respond to inflation by instituting higher interests rates, which consequently affects the growth trend in a country.
According to the Bank of England (2004), inflation hampers long-time planning and development as business prefer to restrict spending to projects that hold the promise of high-returns in a shorter period or those that allows a quick payback. This in turn affects the economic stability of the country.
The effect of inflation on the economy is pegged on the quantity theory of money, which indicates that “if the quantity of money in the hands of purchasers increase or decrease, they will be able to buy, with the same money, a lesser or a greater quantity of goods and services “(Gosh, 1996).
Allen (1997) holds the opinion that the ultimate objective of the UK’s economic activity is to satisfy the consumer. As such, he argues that the Consumer price Index (CPI) should be able to measure the monetary cost of achieving specific levels of utility. Notably, the UK disclaims any intention of having a specific cost in order to maintain customer satisfaction.
The cost of inflation is always high for an economy. This is regardless of whether the inflation was predicted, stable or high. While predicted inflation may be helpful because it assists economists in planning the appropriate monetary policy to use in the future, it still does not shield the economy from the overall effect brought about by the increase of prices.
This mainly is the case because businesses need to keep re-adjusting their prices. Buyers on the other hand cannot budget in advance because of the price uncertainties. Further, there are economists who argue that there is no full proof way of predicting inflation especially when the prices are volatile.
According to the Bank of England, inflation undermines the value of money as a unit of exchange and eventually leads to economic players misdirecting resources, which then leads to wasteful allocation of capital and missed opportunities for growth. According to the Bank’s observation, high inflation makes the messages that prices send to economic analyst vague.
Ideally, the prices of goods and services provide specific signals to the economy on the most likely profitable areas to direct resources. When inflation is high however, the signals are unclear since no one understands whether they are as a result of inflation or related to the individual product.
Monetary Policy
According to the Bank of England (2004), interest rates have always been used to control inflation rates in the UK. But how exactly does the bank do this? Well, according to its 2004 report, changing the interest rates influences the overall amount of expenditure in the country.
When the interest rate is increased, it makes saving attractive and borrowing less attractive. A reduction of interest rates on the other hand makes saving a less attractive economic venture, while appealing to the borrowers. The latter stimulates spending, while the former restricts spending. Ideally, the government observe prevailing trends in the market before either increasing or reducing the interest rates.
The use of interest rates to regulate inflation also affects the currency exchange rates. When the interest rates in the UK rise, investors who have assets in the country get increased returns for their investments. A reduction of the interest rates would also reduce import prices while making UK based assets more appealing to the international market. Unfortunately however, the Bank of England (2004) notes that interest rates do not always affect the exchange rates.
A monetary policy would stabilise the value of money by keeping inflation at low levels. This does not however mean that such a policy would permanently raise growth or output in the economy. However, the fact that the monetary policy creates a better business environment means that individual players can exploit the benefits of low inflation by concentrating on the quality and competitive production of goods and services.
A different monetary policy proposal would be for the UK to adopt a fixed exchange rate. According to Gosh (1996), there is a strong link between inflation and fixed exchange rates. This mainly stems from the discipline and confidence effects that fixed exchange rates give to an economy. However, seeing that exchange rates are affected by various economic variables, this does not look like a very suitable option.
Conclusion
Achieving low inflation rates is touted as the foundation for economic stability of the UK’s economy (Bank of England, 2004). The current target inflation rate is at 2 percent, which the bank argues that it takes into account the change in quality that happens overtime in product and services. This then means that prices cannot remain constant if improvements are made on them.
Overall however, the Bank estimates that if the 2 percent is attained and maintained, the UK government will be able to set economic objectives for investments and job creations.
The 2 percent interest rate is part of the governments monetary policy intended to deliver a more certain economic environment where businesses can make long-term predictions and plans. By delivering monetary stability into the UK economy, the Bank of England will give businesses the room needed to concentrate on competitively producing goods and services for the consumer market without having to worry about inflation and the consequences that it has on their businesses.
References
Allen, W. (1997) Inflation Measurement and Inflation Targets: The UK experience. Bank of England review, 179-185.
Bank of England. (2004) Low Inflation and Business. Web.
Gosh, A. (1996) Does the exchange rate regime matter for inflation and growth? New York: IMF.
Sloman, J. (2007) Essentials of Economics. 4th edition. New Jersey: FT Press.