European Deflation

Latest inflation figures in the UK indicate that deflation could be a major worry in the UK. Inflation in the UK fell to 0.5% which is a worry because if inflation becomes negative, falling prices can lead to a deflationary spiral. Consumers will put off purchasing goods because they know that prices will continue to fall, hence they will be able to save more money by waiting. Furthermore, in the Eurozone, there is deflation of 0.2%. This is one reason why deflation is such as hot topic among economists and businesses (for example, type 'deflation' into Google then click on the 'news' tab to see what comes up).

But I just came across a video on the FT where Sarah Gordon, the business editor, discusses how deflation may not actually be that bad, in the Eurozone. This perspective can also be relevant for the UK. The video explains deflation well and is worth listening to. One of her key arguments is that while inflation remains negative, the CPI is actually positive (0.8%), only being bought down by falling fuel and energy prices. This means that its important to consider what measure of deflation is being used in any figures given. Also, falling fuel prices means that consumers are actually benefiting because living costs have fallen. This might actually increase consumer spending rather than retard it. 

She also mentions that businesses are not worried about deflation because if the European Central Bank embark on a quantitative easing programme, they will buy sovereign and corporate bonds which will reduce interest rates. This is actually good for businesses because it reduces companies' debts.

This video can be accessed here.

UPDATE: The state of the European economy

Recently, Europe’s economy has avoided appearing on many of our news screens what with other international affairs such as Russia/ Ukraine, Syria and Iraq in the headlines for probably my entire summer holidays. But that doesn't mean that the European economy is all hunky-dory and the recession is a thing of the past.

This post is an update of what is actually going on in Europe right now, giving you three key case studies: Italy, France and Germany.

Italy

·      Triple dip recession – GDP fell by 0.2% in the second quarter of 2014

·      12.6% unemployment rate

·      43% youth unemployment

·      Little political will to do anything about it

France

·      Rising budget deficit

·      Last quarter’s GDP growth: 0%!

·      Chance of going back into recession, was also 0% in the quarter before last

Germany

·      GDP fell 0.2% in the last quarter, the first GDP contraction this year

·      Manufacturing sector slow down

·      Geopolitics is affecting growth: Russia’s embargo on European food imports is apparently affecting 9.5m European farmers, and is affecting Germany’s trade

Key points to note about Europe right now:

·      Low inflation.

Average Euro Area: 0.4%

Deflation in 8 Eurozone countries including the PIGS (Portugal, Italy, Greece and Spain)

Country in Eurozone	Inflation rate
France	0.4%
Italy	-0.1%
Germany	0.8%
Spain	-0.5%
Greece	-0.3%
Portugal	0.4%

Why is this a problem?

·           Increases the real value of debt which means that government debt increases making it harder to pay off and increasing the likelihood of needing another bail out

·           Taxes will have to rise eventually to fund the increased debt accumulation which means businesses will have a higher tax burden à leaving some Eurozone countries

·           There is danger of falling into a deflation trap where prices just keep falling. This is called a deflation spiral.

·      High unemployment

·      High government debt

·      Political upheaval

·      Geopolitics with Russia

·      Lack of political union

Different countries in the Eurozone want different things and have different views with how situations should be handled, e.g. with Russia, which makes it hard to manage economic policy and introduce austerity measures where needed.

What can be done?

·           Keep interest rates low – increasing interest rates will just decrease inflation more

·           “Quantitative Easing lite”: the European Central bank buys assets to stimulate the economy and help inflation rise

Anything else?

·           Role of competition in markets:

o   There was a period of very low inflation during the late 19^th century in Germany and the UK

o   Analysis shows there was competition in markets and businesses operated in a competitive environment

o   Competition restricts wage growth because there are many companies in the same industry offering the same job and the same wage. This is happening now!!!

o   A competitive market means that firms are unwilling to increase the price of goods and services – preventing inflation from rising. This is happening now!!!

o   It is therefore hard to increase inflation. This is happening now!!!

Quantitative Easing (QE)

QE causes a change in the money supply. Steps:

1. The Bank of England (BoE) purchases assets such as government bonds and corporate bonds
2. Pays for these assets by creating money electronically and crediting the accounts of the companies that it bought assets from
3. These accounts are called reserves. All banks hold reserves at the BoE and the essence of QE is that it builds up these reserves
4. QE is likely to lead to inflation because banks lend more and increases the money supply (see Quantity Theory of Money). Another reason for inflation is, holding everything else equal (ceteris paribus), more people have more money that they supposedly use for consumption, creating demand pull inflation

Explained by Stephanie Flanders

http://www.bbc.co.uk/news/business-16973560

Stephanie Flanders in the BBC’s economics editor, the link above provides a short video RSAnimate of QE. A summary of the video is as follows:

·         The Bank of England creates money and spends it so that there is “extra cash” flowing into the economy. They spend it by buying government bonds or IOU’s (formal definition: documentation confirming that the debt is owed) from financial institutions such as pension funds or insurance companies.

·         This puts more money into the economy (higher money supply) because these financial institutions that sold these bonds have more money to spend on new businesses or on housing for example.

·         Because of this, it is cheaper for the government to borrow as the BoE pushes up demand for the Treasury’s IOUs and supply of bonds has been reduced. Long term interest rates are lower than they should be making it cheaper for everyone else to borrow as well, because higher demand means more spending and this leads to faster growth.

The last point explains the theory WHY the government uses QE even with the risk of inflation, particularly during recessions. If demand rises, consumption may increase and the economy begins to recover. 

Costs of Inflation

Watch this video about the costs of inflation: http://www.youtube.com/watch?v=9zFQ0KhKkpw&feature=youtu.be

Also see inflation word of the day

Inflation for January 2012

Inflation fell to 3.6% in January, as forecasters predicted. Read more on the Financial Times. The ease in inflation may give signs that this 'stagflation' that the economy has been experiencing may be shifting away. The coming months will tell how unemployment will change in response (Phillips Curve). Inflation faces downward pressure from the effects of higher unemployment, slow exports markets (due to the Eurozone) and lower energy prices (causing a rise in imports).

A further £50bn Quantitative Easing that the MPC authorised earlier this month shows that there is still deficient demand in the economy and it may continue to stay low. Thus economists are predicting more QE to keep inflation from falling below the government's 2% target.

Latest figures

A good website to use to find out the latest growth, inflation, interest, exchange and unemployment rates is http://tradingeconomics.com/. You can spend a while looking at the most recent data and pick out patterns and make comparisons.

Interesting facts to note and use:

Japan's interest rate is 0%

The Euro area has the highest unemployment rate

China's inflation rate is 4.2% while India's is over 9%!

Ireland has the highest budget deficit, 31.30% of GDP. Greece, the USA, UK, Portugal and Spain follow soon after.

India's GDP was 6.9% in the third quarter of 2011, compare that to China's 2.3%

Recent inflation figures!

Once again, the new inflation figures have come out for November and the CPI has fallen 0.2% from the previous month. The RPI also fell from 5.4% to 5.2%.
Reasons for the slight fall in inflation include:

• Supermarket food prices (bread and vegetables) - price war
• Transport costs - fuel prices fell

However, the rate at which prices are rising is still twice that of the rate of increase of wages, making society worse off. Wage rises are not keeping up with inflation, thus in real terms, salaries are falling.

What does the UK's economic growth tell us about the impact of cuts?

This blog was created to help you find resources for your exams, as well as providing specific exam revision notes, so below is the link to an article that talks about government cuts and their impacts on society.

http://www.rsablogs.org.uk/2011/adam-lent/growth-data-impact-cuts/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+rsaprojects+%28RSA+blogs%29

 
Make notes about what you read, and notice that the view of Adam Lent conveys that government cuts have not yet stifled growth.

Phillips Curve

·     The Phillips curve shows the short run trade off between unemployment and the rate of inflation (see July's post).

·     As unemployment falls, inflation rises. Both demand-pull and cost-push inflation can rise due to low unemployment.

·     Demand pull: When more people are in employment, more people have more spending money. Thus consumption increases, leading a shift of the AD curve to the right and a rise in the price level.

·     Cost push: Low unemployment means there is a smaller pool of labour for employees to choose from. This increases trade union bargaining power for higher wages (see here) and thus increases wage inflation. Because it costs firms more to produce the same level of output, they raise the price of the goods they produce to pass on this extra cost to consumers, contributing to a higher rate of inflation.

·     The trade-off illustrates the difficulty faced by policy makers and the government are faced with choosing the most suitable combination of inflation and unemployment rather than completely eliminating/reducing one of them.

·     The Phillips curve is still debated among many economists as they feel it does not hold. One of the criticisms of the Phillips curve is that in the 1970s (use this as a case study in the exam!!), inflation and unemployment were rising at the same time and there was no trade off. This was called stagflation/slumpflation (see Word of the Day in August).

The Phillips Curve relates to the quantity theory of money, so, if you have forgotten why, refresh your memory by clicking here!

In the long run, there is NO trade off between inflation and unemployment, shown in the diagram below. 

NRU is the Non-accelerating inflation Rate of Unemployment. This means that it is the only rate of unemployment that the inflation rate does not change, the natural rate of unemployment. It is also known as the equilibrium level of unemployment.

The Quantity Theory of Money

The quantity theory of money

·       Explains that a rise in the money supply leads to excess demand, leading to a rise in prices, inflation. To put it simply, too much money chasing too few goods.

·       The quantity theory is a special case of demand pull inflation.

·       The Fisher Equation of Exchange provides evidence for the quantity theory of money.

MV = PT

M = money supply               

The total amount of money in circulation in the economy at any given time.

V = velocity

The number of times the money circulates around the economy at any given time. V is influenced by methods of payments such as cash, bank overdrafts, credit or debit. Methods of payments are limited therefore V remains constant.

P = price level

T = total transactions

The measure of all the purchases of goods and services in the economy. T remains constant because the theory assumes money is a medium of exchange, not a store of value, therefore people spend quickly any money they receive.

If V and T remain constant, they cancel each other out and thus a M = P. This means that a rise in M will create a rise in P, therefore explaining the theory.

Criticisms

Keynesians generally reject the theory because….

1. There are too many assumptions that the theory relies upon. They don’t believe that people quickly spend any money they receive. Instead, people hold money balances if share prices/bonds are likely to fall for example, thus V and T cannot remain constant.

2.  If there is spare capacity in the economy, Keynesians believe that real output and employment will increase, not the price level. However a counter-argument for that would be the Phillips Curve (more on that to come!).

3. If M has increased, the effect it can have on P is limited if V balances out the increase in P. Reflation of the economy can further limit the effect of a rising money supply on the price level.

4. Reverse causation: Inflation causes an increase in the money supply, not the other way round. Cost push inflation occurs and the money supply adapts (by rising) to finance a higher price level set for consumers to pay.

Inflation to be highest rate for 3 years

This article here highlights that inflation CPI is expected, by city forecasters, to hit 4.9% or even as high as 5.1%. Please read the whole article as it contains information about that rate of pensions increases and past inflation, which is very beneficial to know for the exam!

The Quantity Theory of Money

The quantity theory of money

·       Explains that a rise in the money supply leads to excess demand, leading to a rise in prices, inflation. To put it simply, too much money chasing too few goods.

·       The quantity theory is a special case of demand pull inflation.

·       The Fisher Equation of Exchange provides evidence for the quantity theory of money.

MV = PT

M = money supply               

The total amount of money in circulation in the economy at any given time.

V = velocity

The number of times the money circulates around the economy at any given time. V is influenced by methods of payments such as cash, bank overdrafts, credit or debit. Methods of payments are limited therefore V remains constant.

P = price level

T = total transactions

The measure of all the purchases of goods and services in the economy. T remains constant because the theory assumes money is a medium of exchange, not a store of value, therefore people spend quickly any money they receive.

If V and T remain constant, they cancel each other out and thus a M = P. This means that a rise in M will create a rise in P, therefore explaining the theory.

Criticisms

Keynesians generally reject the theory because….

1. There are too many assumptions that the theory relies upon. They don’t believe that people quickly spend any money they receive. Instead, people hold money balances if share prices/bonds are likely to fall for example, thus V and T cannot remain constant.

2.  If there is spare capacity in the economy, Keynesians believe that real output and employment will increase, not the price level. However a counter-argument for that would be the Phillips Curve (more on that to come!).

3. If M has increased, the effect it can have on P is limited if V balances out the increase in P. Reflation of the economy can further limit the effect of a rising money supply on the price level.

4. Reverse causation: Inflation causes an increase in the money supply, not the other way round. Cost push inflation occurs and the money supply adapts (by rising) to finance a higher price level set for consumers to pay.

Word of the Day

Inflation

A continuous rise in the average price level. Measured by the Retail Price Index (RPI) and the Consumer Price Index (CPI). The RPI contains mortgage interest payments thus it is always larger than the CPI. Usually inflation is measured by the CPI. In the UK, the current rate of inflation is 4.5% (June) while the Bank of England's target rate of inflation is 2%.