OxBowBusiness: Inflation

11 March 2006

Inflation

This post simply reflects the fact that anyone studying business, economics and accounting related subjects really should be reading the articles and papers published by the Bank of England.

In this post I am going to highlight the main points stemming from the BoE booklet from 2004 entitled Low Inflation and Business (hyperlink to the PDF given at the end of this post).

Firstly, the purpose behind the BoE booklet:

The United Kingdom has experienced low and stable inflation over recent years. This has probably diluted memories of the high inflation and economic instability that once seemed to characterise the UK economy. This pamphlet explains why economic well being depends on maintaining stable prices. It outlines the benefits of low inflation to business and the wider community and describes how the Bank of England undertakes the task of setting interest rates to meet the Government’s inflation target.

Secondly, how does the BoE define inflation ... is this the same as the definition you use?

... inflation ... is a widespread rise in the level of prices across the economy.

There is a perhaps surprising chart (see the end of this post for a copy of it) in the booklet in that inflation in the UK was pretty stable over the period 1700 to around 1920. Since 1920, however, the behaviour of UK inflation has changed dramatically. Sorry but the quality of the image here isn't as good as it is in the booklet (right click the picture and save it and it will look good!): the impression it creates is clear except atht the vertical scale is logarithmic ... what does that mean and how does it have an effect on the impression that an arithmetical scale would have?

Just look at the commentary on this chart on page 2 of the booklet ... download it from the BoE site ... link provided at the end of this post.

There are two further charts that help to explain what generates inflation: growth of the economy and the money supply. Not shown here because of the quality issue. They also mention the shock to inflation of such things as sudden and significant oil price rises.

What's Wrong with High Inflation

The BoE make a good job of telling us why high rates of inflation can be a bad thing. They also make the point that the UK suffered very badly from high rates of inflation in the 1970s and into the 1980s. Here are the headings the BoE uses in this section:

Hampers longer term planning
Increases risk and borrowing costs
Economic instability
Misdirects resources
Less equitable

Read the booklet to find out what they say under each heading: although I have changed the order of these five points, I think the first three are clear and you can guess what the BoE says here but the second two might be a bit more difficult for some of you.

Inflation Flowchart

There is a very useful flowchart (repeated at the end of this posting) that the BoE has presented that helps to explain how inflation really comes about. The flowchart follows and again, if the quality of the graph is not so high for you, right click and save it and deal with it from there!

The rest of the booklet then takes us through that flowchart and discusses both the way the monetary policy committee (mpc) works and includes a number of useful points on the good points concerning low rates of inflation.

Lower Inflation

Lower interest rates can affect consumers’ and firms’ cash flow: a fall in interest rates reduces the income from savings and the interest payments due on loans.
Lower interest rates can boost the prices of assets such as shares and houses.
Changes in interest rates can also affect the exchange rate. You need to read page 5 of the booklet to follow up on this assertion.
So lowering or raising interest rates affects spending ... Changes in spending feed through into output and, in turn, into employment
The Bank’s remit is to deliver price stability, as defined by the Government’s inflation target of 2% and, subject to that, to support the Government’s economic objectives including those for growth and employment.

There is a key question stemming from any debate on UK inflation which is why is the target set at 2% ... read page 7 of the booklet!

Finally, on page 8, the BoE says this:

Achieving and maintaining low and stable inflation is a foundation for many of the economic and social objectives that most people would want to see achieved. Crucially, it is an essential ingredient for sustainable growth in investment, output and jobs. The present monetary policy framework is designed to deliver a more certain environment in which businesses can plan and operate. If the Bank of England can deliver monetary stability, businesses can concentrate on what they are good at, producing competitive goods and services, without having to be concerned about high inflation and its consequences. That is a big difference.

Graphics

Double click thes graphics to enlarge them: right click to save them