Inflation

On Tuesday in econ101b we looked at inflation alongside unemployment for the first time. We're going to return to these later in term in more detail, but for now we thought a little about the different types of inflation (CPI, GDP deflator, producer price inflation and wage inflation), and also the theoretical concepts of demand-pull and cost-push inflation.

Simon Wren-Lewis, who I've mentioned previously, blogs today on inflation, and in particular the idea that we're about to see a 1970s style explosion in inflation.  As Simon points out, it isn't fools that are warning about this - he links up to Andrew Sentance, who until recently was on the Monetary Policymaking Committee (more later in term on what this does - suffice to say for now it does what it says on the tin).

A regularly aired concern is that because of quantitative easing (again, more later in term), which can be described in a simplification as printing money, inflation is just around the corner - once people spend all that money that's out there.

Wren-Lewis though makes an astute observation - wage inflation has been lower than price inflation, something I pointed out in the lecture yesterday - which means that people simply don't have the extra money to spend, which may then lead to inflation - what happened in the 1970s, as Wren-Lewis's graphs show.

Wages are increasing at a slower rate than the general price level, which means that we are all getting poorer in terms of what we can actually afford with our wages - which means we are unlikely to start spending more, a precursor to higher inflation (aggregate demand increasing).

Summer activity

It's summer and although not formally term time, I tend to keep posting on here regardless with hopefully interesting stuff in case former students are still tuning in, so to speak.

Of interest yesterday, alongside the injustice handed out to Ukraine by human error (and some economics - why did UEFA really think adding more scope for human error was better than goal line technology?), was inflation falling to 2.8%, its lowest level for quite a while. Importantly, firmly back within the target range.

How is that possible, given all this quantitative easing and continued budget deficits? You'll recall the former adds liquid assets to the economy in place of illiquid ones hence should see more spending. The latter also adds more money into the economy by putting unearned money in the hands of unemployed people and such, and via spending projects for example related to the Olympics.

The answer is that this extra money, for now, isn't being spent. You'll also recall the aggregate demand (AD) aggregate supply explanation for price level determination and hence inflation. If AD stays in the same place since we don't spend then we won't get inflation despite supposedly inflationary policies.

Assignment 2...

Depending on how much you enjoyed the alternative arrangements now in place for classes on econ101b, you'll either be delighted or daunted by the fact that Assignment 2 is now on WebCT...

The first question asks you to look at a plot of unemployment rates for the UK and a few other countries. In there is both the claimant count unemployment rate, and the standardised rate - two ways of measuring unemployment. As you'll see, the two do differ; the plot of unemployment on the assignment is:

The red lines are UK data, as the legend (top left) shows. The solid red line is the standardised rate, the dotted line the claimant count, and as was discussed in class, often (but not always), the claimant count is below the standardised rate - often considerably so - in 2005 the standardised rate was nearly 5% while the claimant count was just over 2.5%. What drives these kinds of differences?

Moreover, what has unemployment done in the UK over the years?  There's a fascinating discussion of unemployment in the UK on the blog Not the Treasury View, which looks at structural unemployment and something they call the unemployment gap. The blog talks about factors that have influenced unemployment in recent years, and may help you think about this. When was unemployment high, and why might it have been high? When was it low, and what helped it to become so low?

Moving on to inflation, the plot for the second question on the assignment is:

We have data here for CPI inflation for all goods. We could restrict it to core inflation, which excluded energy and food prices - if you're keen, you could search for that data on the OECD Statistics website and compare it to these inflation rates. What you may well find is that core inflation rates between countries differ a little more - the inflation rates we've plotted here include energy and food prices, which are globally traded items and hence a high price of energy in one country is a high price elsewhere too.

Why has the UK had a particular inflation history? What factors have influenced the UK? What about the recent inflationary history, since around 2006 or so?

I'm looking forward to reading your blogs - do let me know links when you've set your blogs up and don't be shy - making your blog more publicly available is a real asset and something that'll look great on your CV in years to come, and will help create even better discussions amongst your class mates.

Enjoy assignment 2 and your classes in weeks 5 and 6!

The Bank of England's Big Decision

In about half an hour, the Bank of England will announce its decision on interest rates. Each month, on the first or second Thursday, the Monetary Policy Committee (MPC) of the Bank of England meets to decide on monetary policy. The main tool of monetary policy used by economies around the world currently is the interest rate, and the MPC will decide whether it is going to keep the interest rate on hold for another month at its lowest practical value of 0.5%, or whether it will increase interest rates. It faces a tough decision.

Later in term we'll talk quite a bit about monetary and fiscal policy and we'll start to understand just why this decision is so tough. In any state of the world it is hard to forecast and know what is going to happen in the future and hence know the right thing to do with monetary policy.

Currently the Bank has a problem in that economic growth is negative yet inflation is above its target (of 2%). In an ideal world, the Bank would have one of these two problems to deal with, because they demand conflicting responses. Negative growth demands loose monetary policy, hence low interest rates, in order to stimulate economic activity. But high inflation demands tight monetary policy, hence higher interest rates, in order to keep economic activity in check and thus keep inflation down.

There's another part of this difficult question though which the Bank must factor in: Much of our inflation is imported from abroad, as the pound has lost so much value in recent years. As we've learnt recently, if interest rates did rise here in the UK, it is possible that the exchange rate would appreciate, hence reducing that imported inflation effect.

Either way, we lie in wait for the decision, expected in about 24 minutes...

Monetary and Fiscal Policy

Later in term we cover these two things in detail - for now we just hint at them, and having looked at inflation in yesterday's lecture while thinking also about unemployment and yesterday's surprising GDP growth figures announced by the ONS, last night Mervyn King (Governer of Bank of England) made a speech in Newcastle about the UK economy.

In it he mentioned the problems he faces as the head of the Bank of England, which is in control of fighting inflation: He expects inflation to rise to 5% in 2011, yet the Bank's target is 2% (plus or minus 1% so a range of 1-3%). Yet GDP growth was negative in 2010Q4, and is not expected to perk up any time soon.

The problem is that high inflation would usually be met by the Bank of England with higher interest rates, yet growth is weak: And higher interest rates would hurt growth (we'll study the interest rate transmission channel from interest rates to economic activity later in term).

The fundamental problem is that of the two basic types of inflation covered yesterday, demand-pull and cost-push, the UK is suffering cost-push at the moment: The weak exchange rate imports inflation, and commodity prices are high at the moment - both factors that makes inputs more expensive.

However, as also mentioned, inflation can come simply from expectations becoming reality. If people start expecting higher inflation then they will attempt to build that into their wage settlements, particularly if and when the economy begins to recover. Then with more money in the economy, this will likely translate into higher actual inflation. So the current cost-push inflation may turn into demand-pull inflation, and this is what the Bank of England is seeking to avoid.

It seeks to avoid it precisely with speeches like this, attempting to show us that it knows what it is talking about when it comes to the economy...

Inflation Higher

The Office for National Statistics releases data on inflation month by month. We talked a little about inflation yesterday, and will go into much greater detail next week: Inflation is the change in the price level. That's a wonderfully vague definition which you'll have to improve on a little for assignments and the final exam. What price level? Whose price level?

The ONS calculates a number of price indices: Numbers that reflect the level of prices for a collection (or bundle or basket) of goods. Inflation then, according to one of these indices, is the change, year-on-year. So the number announced today was the increase in prices in December 2010 relative to December 2009. We compare year-on-year to account for seasonal patterns that might distort our understanding of what's going on in the economy. Whichever way you look at it, inflation is high.

The Bank of England is set a target of 2% for inflation, yet it was nearly 4%. This creates problems for the Bank of England because inflation is relatively high, yet GDP growth is still fairly embryonic after the recession. Any attempt to curtail inflation by the Bank of England will put downward pressure on economic growth, and hence would not be helpful.

Yet the longer inflation remains higher than target, and particularly with the VAT rise that we've just had at the start of 2011, the more it starts to get built into new wage settlements by workers. If workers are paid more, this will likely lead to higher inflation since consumers have more money to spend while supply levels haven't adjusted.

More next week...

The Item Club and Interest Rates

As I mentioned in the lecture this morning, the Item Club of Ernst and Young provide an alternative take on the economy from the Monetary Policy Committee of the Bank of England (the committee that decides what interest rates should be - this is monetary policy, which we will consider later in term).

As described by the BBC, the Item Club thinks interest rates should remain at 0.5%, where they currently are. Monetary policy is one of the tools a government has through which to manipulate economic activity; the other main tool is fiscal policy: Government spending and taxation.

Given that the Coalition government is planning to cut government spending and has already begun raising taxes via the VAT rise, economists describe fiscal policy as tight. This means that, as we will note this term in lectures, fiscal policy will restrain economic activity by contributing to a decrease in aggregate demand.

Given this, the Item Club argue that monetary policy cannot similarly be tight. A tight monetary policy would be a policy stance aimed at achieving a fall in aggregate demand. If both policies were tight, then the decrease in aggregate demand would be even stronger resulting in much slower economic growth, and potentially another recession.

Hence the Item Club rightly, in my opinion, argues that monetary policy must remain loose, and hence interest rates should remain low.

However, inflation is above the target the Bank of England is set, and hence this is why some have argued that interest rates should rise. When we get to monetary policy later in term we will get to discuss what impact interest rates have, and hence what the role of monetary policy is.

Gold is very valuable and immensely powerful

More on gold. And inflation. This article by David Leonhardt ridicules the media and others who continually talk about new record high prices in commodities such as oil or gold: They aren't adjusting for inflation! Inflation means that it costs more pounds or dollars to get the same thing at a later point in time, as you probably are well aware of. So that means that prices generally rise, and hence new record highs can be quite common.

It's a nice little explanation of this. The article then talks about the wider agenda of people touting the price of gold and is quite complicated. The first bit about adjusting for inflation though is somewhat amusing...

What do Central Banks do?

I'm lecturer for second term (econ101b), which is macroeconomics. Currently Martin Jensen is lecturing you on microeconomics, and so when I post I'll be pointing you towards macroeconomic events and news and how that links in to what we'll look at next term.

One thing we'll ask next term is: What do Central Banks do? They are always in the news, particularly around Monetary Policy Committee (MPC) meeting times in the UK. The Bank of England is the Central Bank for the UK. In the US, a system called the Federal Reserve System operates in place of a single Central Bank, and there are Federal Reserves of a number of regions in the US - Minneapolis, New York, Philadelphia, San Francisco, etc. But they all hang together under the Federal Reserve, naturally headquartered in Washington. Their equivalent of the MPC called the FOMC, or the Federal Open Market Committee.*

But what do these Central Banks actually do? Generally they are given responsibility for monetary policy in most economies: The MPC sets interest rates to achieve an inflation target, the idea being that if inflation is kept low and stable, the macroeconomy will stay roughly in order. In the US, the objective of the Federal Reserve is a little wider than just inflation and includes the wider macroeconomy.

There have been many criticisms over the years about whether targetting is the right thing: What's the right target? Why just inflation? Why not asset prices? What is the effect of different targets? An alternative school of thought, pushed more than most by an economist called Scott Sumner, is that Central Banks should target nominal GDP (that's GDP in the actual prices we pay before any correction is carried out for inflation).

It turns out that in its most recent meeting the FOMC hinted it may well begin such a targetting exercise. Next term we'll consider much more what this actually means, other that at the basic level it means that the Federal Reserve would target a particular level of nominal GDP (NGDP) and hence choose interest rates and other monetary tools in order to achieve this aim, just like currently the Bank of England chooses interest rates to achieve 2% inflation.

*: Despite the prevalence of Wikipedia links in this post, the advice is: Don't rely on Wikipedia. Anyone can edit it and hence put false information in there. Rely instead, if you need to for referencing, on something like the New Palgrave Dictionary of Economics. If you refer to Wikipedia in any assignments you hand in, you'll likely incur the wrath of your tutor!

Price Indices

In econ101b next term, you'll learn about inflation. Inflation is the phenomenon of rising prices and the term is applied to individual prices and prices more generally. Inflation matters: One of the main goals of macroeconomic policy is to keep prices low and stable, one way or another. This is important because if prices are low and stable, they are predictable, and consumers know how much they need to spend, as do firms, making rates of return on investments a safer proposition.

The question, of course, is exactly how do you measure it? Official statistics are usually what are called Consumer Price Indices (CPIs). But they are based on a basket of goods (literally, the types of goods the "average" family buys), and hence measure the changes in prices of these goods.

But who is this average family, and is this really the most important thing for government policy to be targetting? Already people are asking whether it makes sense when the kinds of goods poor folk buy are very different to the kinds of goods rich people buy (see here), but the latest development is perhaps not entirely surprising: The Google Price Index.

The idea is that Google will use the ridiculous volumes of information it has at its disposal to measure inflation - just how much are prices changing of the goods that people are actually buying (based on what they do on Google?). There are many possible advantages of such an index - it could be released daily (whereas official statistics are monthly), and it would likely be easily updated to reflect new trends in consumption (it is commonly reported (but I can't find a link!) that until very recently candles were still a main item in the CPI calculation).

If you're unaware of the many things Google has done since it has had Hal Varian as its Chief Economist, there is at the bare minimum Google Trends and its use for things like prediction Bird Flu from internet searches.