Macroeconomics Paper

The recent up tick in UK inflation has sparked inflation concerns to continue going into 2009. However the Market Oracle anticipated the recent up tick as a consequence of money supply growth earlier in the year as an indicator of future inflation and that the up tick would prove temporary as many factors converge towards deflationary pressures during 2009 that will allow the Bank of England to start cutting UK interest rates towards a target of 5% before the decline in UK inflation starts and for UK inflation to subsequently fall towards the Market Oracle targets of 3% RPI and 1.8% CPI towards the end of 2009.

Demand pull inflation

The British economy has experienced inflation throughout the last thirty years - but the rate at which prices have been rising has not been stable. The chart below tracks the annual rate of inflation for the British economy over the last fifty years. In an open economy (i.e. a country that engages in international trade), price inflation can be caused by a number of factors. Economists divide them into two main groups, demand-pull and cost-push inflation.

Demand Pull inflation occurs when total demand for goods and services exceeds total supply. This type of inflation happens when there has been excessive growth in aggregate demand and there is an inflationary gap.

Demand-pull inflation is often monetary in origin - because the authorities allow the money supply to grow faster than the ability of the economy to supply goods and services. The phrase that is often used is that there is "too much money chasing too few goods"

When aggregate demand increases from AD1 to AD2 the economy is moving towards the full employment of factors of production. Many firms choose to increase price to widen profit margins. Shortages of factor inputs mean that the firms' costs of production start to rise. Furthermore, it is likely that, as employment in the economy grows, demand for goods and services will become more inelastic. This will allow firms to pass on large price increases (P1 - P2) without any significant fall in demand.

Main causes of increased aggregate demand:

A depreciation of the exchange rate increases the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while foreigners buy more exports, demand in the UK economy will rise. If the economy is already at full employment, it is hard to increase output and prices are pulled upwards.

A reduction in direct or indirect taxation: If taxes are reduced consumers will have more disposable income causing demand to rise. A reduction in indirect taxes (taxes on goods and services such as VAT) will mean that a given amount of income will now buy a greater real volume of goods and services.

Rapid growth of the money supply as a consequence of increased bank and building society borrowing if interest rates are low and consumer confidence is high

Cost push inflation

In an open economy such as the UK, there are many potential sources of inflationary ...