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Economics 100 Assignment option 2 Lecture: Ms Maria Lantzke Thursday 8. 30 am to 12. 30 pm Table of contents 1. Article summary ………………………………………………………. 3 2. Introduction …………………………………………………………….. 3 3. Analysis ……………………………………………………………………………………….. 3 1. UK Inflation Rate ……………………………………………….. 3 – Definition of inflation …………………………………………. 3 – Causes of inflation ……………………………………………. 4 2. Consumer price index …………………………………………….. – Definition of Consumer price index ………….. ……………… 5 – Increasing CPI in UK.. ……….. ………………………………. .5 3. Business cycle ……………………………………………………. 6 – Definition of Business cycle ………………………………… ….. 6 – Business cycle in UK…………………………….. ……………… 6 3. 4 Interest rate and monetary policy …………………………………. 6 – Expansionary monetary policy……….. …………………………6 – Contractionary monetary policy………………. …….. ….. ………. 7 4. 0 Conclusion ………………………………………………………………. 9 5. 0 Reference list …………………………………….. …………………… 10 1. 0 Article summary This article called “UK inflation rate rises to 4% in January” was posted on February 15, 2011 by BBC. It displays increased inflation rate in Unites Kingdom. Indeed, The UK Consumer Prices Index (CPI) annual inflation rate rose to 4% in January. This CPI figure picked up highest since November 2008. Monetary policy committee (MPC) is considering a possible increase in the interest rate to try to cool inflation. However there are contrasting opinions about when the Central Bank should increase it.
In addition, the article refers to the causes of inflation. Mr. King, the Bank of England governor, recognizes possible causes of inflation in the VAT rise, the fall in the pound and recent rises in commodity prices. However, Chancellor G. Osborne disagrees about the VAT rise as a cause of inflation. Furthermore, in this article there are more others causes of inflation: the high price of petrol and crude oil, global changes in the price of foods and commodities. 2. Introduction This report provides an analysis of inflation in UK with applying some economics theories.
The inflation rate picked up 4% in January which is highest since November 2008. In this article there are four main concepts of macroeconomics, such as inflation and CPI, interest rate and monetary policy. The purpose of the report is to describe the economic problems in England, through the analysis of these economics theories. 3. 0 Analysis 3. 1 Inflation rate Inflation is the sustained increase in the general level of prices in the economic (Hubbard et al. 2010). It’s measured by the price level, which measures the average prices of goods and services in the economy.
The figure of percentage increase in the price level from one year to next is called inflation rate. In UK, the inflation rate rose above the 2% target. Bank of England governor, Mr. King, believes the inflation will rise towards 5% in the next months and MMC thinks that high inflation is just temporary as it will fall below the target in 3 years. However, Inflation below the target of 2% is judged to be just as bad as inflation above the target. Causes of inflation Inflation is usually categorized as demand-pull or cost-push.
Demand-pull inflation is a rise in general price level in the economy caused by an increase in the aggregate demand and production levels are not able to meet the high demand immediately (Hubbard et al. 2010) Cost push inflation is a rise in general price level in the economy caused by a decrease in the aggregate supply of goods and services. Aggregate supply decrease when there is an increase in price of inputs, such as raw materials, equipments, machinery. [pic] Figure 1 Cost-push inflation Figure 1 shows the process of cost-push inflation; 1. The economy is riginally at equilibrium at point A, with the price level P1 and real GDP Y1. 2. A supply shock moves the aggregate supply curve to the left, from SRAS1 to SRAS2, which leads to a fall in real GDP below its potential level and a rise in the price level from P1 to P2 (Hubbard et al. 2010). The article refers to a rise of prices of petrol and crude oil, two essential raw materials, as two causes of inflation. The higher oil price affects others related with it such as cars, factories, any machineries operated by oil. And also mortgage interest payment has been increased from 4. 8% to 5. 1% as Retail Prices Index (RPI).
There are no evidences about a rise in demand for goods and services. Therefore UK inflation can be considered cost-push inflation. 3. 2 Consumer price index The Consumer Price Index (CPI) is an average of the prices of goods and services purchased by the typical family. CPI is also called “cost of living index” as it measures the cost to the typical family to buy a representative basket of goods and services. Office for National Statistics (ONS) review “the “shopping basket” every year and decide which items taking outside and which bringing in, to reflect changes in the market (Topic guide to: Price Indices and Inflation. . d. ). Despite CPI is the most popular measure of inflation, it has some disadvantages as it can’t measure the substitution bias, increase in quality bias, new product bias and outlet bias. . – substitution bias: ONS assumes that consumers buy the same quantity of each product in the market basket each month, while consumers are likely to substitute a product, whose price goes up, with a cheaper one. . – Increase in quality bias: products can improve in quality and therefore the higher prices will reflect also the higher quality of these products. However CPI can’t measure quality of products. – New product bias: ONS updates “the shopping basket” every year, but during this period of time a lot of new products, such as new technology tools, can come out in the market. However new products are not included in CPI. . – Outlet bias: many people buy products from discount stores or via internet, while ONS collects price statistics just from traditional full-price retail stores. So CPI cannot always reflect the prices that consumers actually pay. CPI in UK rose to 4% in January, highest record since November 2008. According to the article, “The price of petrol as measured by the CPI was ? . 27 a liter in January 2011, which the Office for National Statistics said was a record high. ” In addition, there has been an increase in price of food, commodities, costs of transport, furniture, alcohol and UK government rose VAT from 17. 5% to 20% in January. 3. Business cycle Business cycle consists in alternating periods of economic expansion and economic recession. According to the article, UK economy contracted by 0. 5% in the final quarter of 2010, going in recession phase. In the recession phase employment, production and income decrease.
Generally, during recession, inflation rate goes down as there is a decline in consumption. As a consequence, firms have problems to sell their products and will not raise prices. However, in UK the inflation is keeping on rising, but MPC believes that inflation is temporary and will be below the target in three years. 4. Interest rate and monetary policy Monetary policy is one of the tools that central banks use to influence economy. Using its monetary authority to control the supply and availability of money, the central banks attempt to influence the overall level of economic activity in line with their objectives.
The objectives of the Bank of England are: maintaining price stability – low inflation – and supporting economic growth. Price stability is defined by the Government’s inflation target of 2%. In 1998 Bank of England was recognized independent to set interest rates from the government. The legislation provides that if, in extreme circumstances, the Government has the power to give instructions to the Bank on interest rates for a limited period (Monetary Policy Framework. n. d. ). The Monetary Policy Committee (MPC) is a special committee, which meets monthly to decide the level of interest rates.
It is chaired by the Governor of the Bank of England, Mr. King (Monetary Policy Framework. n. d. ). The central bank can decide to undertake expansionary monetary policy or contractionary monetary policy. Expansionary monetary policy Expansionary monetary policy consists on actions taken by the central bank to increase economic growth rate, by decreasing interest rate. Indeed lower interest rate increases real GDP and the aggregate demand as: – Lower interest rate causes consumption to increase and discourage people to save money – Lower interest rate causes investment to increase as borrowing money will be less expensive.
Therefore firms will find convenient borrow money from the banks to engage in new investment projects. As it’s shown, lower interest rate stimulate AG and the new equilibrium of economy will occur at the new potential RGDP. However, as AD and GDP rise, also the price level will rise, increasing inflation. [pic] Figure 2 expansionary monetary policy At the beginning the economy is in equilibrium at point A. During the time, LRAS1 shifts to LRAS2.
Without expansionary monetary, AD1 will shift to AD2 (without policy),which is below the potential RGDP. By lowering interest rate, the central bank increase consumption, investment and net export sufficiently to shift AD1 to AD2 (with policy). New equilibrium is at point C. The price level at point C is higher than it would have been without policy. Contractionary monetary policy On the contrary, contractionary monetary policy consists on actions taken by the central bank to reduce too fast economic growth and inflation rate, by increasing interest rate.
Higher interest rate causes AD to decrease as: – Consumption declines and people find more profitable saving money – Investment declines as borrowing money become more expensive for the firms. Therefore firms are not stimulated to do new investment projects. As it’s shown, higher interest rate causes AD to decrease. As a consequence, price level and RGDP will decrease as well, leading to a decline of inflation rate. [pic] Figure 3 Contractionary monetary policy This figure shows an example of contractionary monetary policy. High inflation in UK “will put pressure on the Bank of England to lift nterest rates to curb accelerating inflation”. As we seen before, increases in interest rate can be an efficient tool to reduce inflation. However contractionary monetary policy is used generally when the economy is growing too fast, but in the case of UK, the economic growth rate decreased by 0. 5%. Therefore, an expansionary monetary policy with low interest rate should help the economy to revitalize as firms and households are willing to spend more and to be engaged in new investments. According to the article “interest rates have remained so far a historic low of 0. % for the 23rd consecutive month”. 4. 0 CONCLUSION To sum up, the Bank of England is waiting to see the next inflation rate and the government actions, before taking any decisions. The interest rate is still at the low percentage of 0. 5% and the central bank hopes that it helps to turn around the economy. Despite of the Bank’s conviction that inflation is just temporary, it’s estimated an additional rise to about 5%. Therefore an increase in interest rate will occur for sure in the future, but still it’s not certain when it’s the best time to do it. . 0 REFRENCE LIST Hubbard, Anne M. Garnett, Philip Lewis, Anthony Patrick O’Brien. 2010. Essentials of economics. Frenchs Forest, NSW. Pearson Australia. UK Nationl Statisstics, Topic guide to: Price Indices and Inflation. n. d. http://www. statistics. gov. uk/hub/economy/prices-output-and-productivity/price-indices-and-inflation/index. html (accessed May 18, 2011) Bank of England, Monetary Policy Framework. n. d. http://www. bankofengland. co. uk/monetarypolicy/framework. htm (accessed May 19, 2011)