In this project I will be looking at how the inflation rates have changed in the UK since 1991. Specifically I will be looking at whether the independence of the Bank of England and the introduction of the Monetary Policy Committee (MPC) has had any major effects on keeping a low and stable level of inflation within the UK. I will be looking at how inflation has been controlled, the theories around it and whether or not they have worked in practice. Background The MPC was first informally established in 1997, and then more formally by the Bank of England Act in 1998.
The Committee's role is to deliver price stability, as defined by the government's policy on inflation, by adjusting the interest rates in the short term to either increase or decrease the population's spending power. Before the MPC was established and the Bank of England made independent the decisions on whether or not interest rates would be changed were made by the government at the time. This meant that the decisions were not always made in the best interests of the economy but to gain some short-term support for the government.
This is one of the main reasons why the Bank of England was made independent. The Bank of England also decides on how much more money is going to be put into the UK economy each year. While this is not a decision that it is made by the MPC it was also changed to independent control from government, but following government guidelines, following the Bank of England Act. Theory Monetary policy can be used as a method to control inflation within an economy. This is usually done by the manipulation of interest rates to either increase or to decrease the spending power of the population of that economy.
This is a particularly useful method to use within the UK as the majority of people own their own homes, as most of these people will have a mortgage and therefore any change in interest rates will directly affect their spending power. This can be shown in a simple example: if a family own a home where they are paying i?? 700 a month for their mortgage while interest rates are 8%, a decrease in interest rates to 5% will mean that they are now having to pay i?? 438 per month on their mortgage. This means that the family will have i??
268 less per month to spend on other goods and services. Aggregate demand is made up of all demands or expenditures in the economy at any given price, and consumption is a major part of the equation; AD = C + I + G + (X-M) This means that a drop in interest rates will mean that a large number of people will be able to spend a lot more money per month on other forms of expenditure. This shows how an increase in consumption will shift aggregate demand to the right and thus prices will increase from P1 to P2.
This can be shown in a more detailed way by looking at Monetarist Transmission Mechanism. This shows how an increase in the money supplied via a fall in interest rates will, in the short run lead to an increase in aggregate demand. This shows the effect that a change in interest rates could have on investment, and it has been explained about how it can affect consumer spending, this proves that it will definitely cause a shift to the right in aggregate demand.
It will also have an effect on the economy by changing the exchange rate. If interest rates fall then so will the value of the pound against other currencies. This is because fewer people will want to keep the money in British banks, as they will be receiving less interest on their investments. This will reduce the number of people trying to buy pounds, which reduces its value on the exchange rate markets. This will give the UK a more competitive edge internationally, therefore increasing the amount of exported goods.
All of these things have meant that inflation will have happened in the short run. In the long run this will cause more inflation as the price rises caused by shifts in the aggregate demand line will lead to a shift in the short run aggregate supply line. There is another theory as why there can be increases in the prices of goods and this is called the Quantity Theory of Money, this is a Monetarist theory which relates price increases to increases in the supply of money. It works through this equation: MV=PT
This is where M stands for money supplied into the economy, V is for the speed of the money, P is the prices of goods and T is the total transactions or output of the economy. For this to work economists have made three important assumptions. These are; that V is always constant, that T is always constant and that this equation will only happen in the left to right direction, this means that an increase in money supplied will cause an increase in prices but an increase in prices wont cause an increase in the money supplied.
This then shows that if the amount of money supplied to an economy is increased then prices will inevitably go up. All of the ways that have been shown, to cause inflation, are monetarist methods, and these are under the control of the Bank of England. However there are some other possible reasons as to why inflation is caused and these are the Keynesian theories and they believe that it is changes to aggregate demand through fiscal policy, as opposed to monetary policy, that are the main causes of inflation.
And these will be out of the control of Bank of England, so the introduction of an independent bank and the MPC to deal with inflation should not have made such a real difference on inflation rates. It is more the issues such as taxes and whether governments are running a surplus or a deficit on their budgets that should make the difference on inflation rates. The main emphasis is that too much money chasing too few goods causes inflation. Pure Keynesian views are very unrealistic, as they believe that the aggregate supply line is horizontal until an economy reaches a full level of employment.
This means that any increases in aggregate demand will cause inflation if the economy is operating at full employment. Other factors that could cause this type of inflation are either wartime or post-war time conditions, as there is nearly always a shortage of goods here, a continual export surplus – where one would have lots of goods leaving the country and just money coming back in or a race for economic growth where producing more income is not matched by the extra output. For this pure theory to be true three assumptions have to be made:
1. All labour is equally efficient 2. All labour is completely mobile both in the occupational and geographic sense 3. That all capital is mobile, i. e. it can turn from the provision of one product in one part of the country to making something else in another part very quickly This is why this is seen as an unrealistic theory, the more realistic Keynesian theory uses the same principles but not to such a strict structure. It is known as Bottleneck or Structural Rigidity Inflation.
This is more realistic as it shows that the closer an economy gets to full levels of employment more shortages start to appear in areas such as raw materials, trained and efficient labour and the production of the finished product. Companies will also encounter the problems of having to deal with labour that is unprepared to move houses or do not have the sufficient skills to do the job that is needed. This along with boosts to aggregate demand will cause inflation. All of the theories of the causes of inflation that have been outlined so far are for demand-pull inflation.
It is also possible that the inflation could have been caused by either expectation led inflation or cost-push inflation. Expectation based inflation is where the expectation that there will be inflation causes inflation to occur. This can be explained through an example; if employees expect there is going to be 10% inflation over the next year they are going to demand at least a 10% wage increase, employers give in to this and pass on the 10% in the form of a 10% price increase. This will result in 10% inflation regardless of the prevailing economic conditions.
The argument against this is that this can not be the cause of inflation only a way of persisting it. If inflation has been 3% in the past then it is very unlikely that the employees will expect 10% inflation, it will only be if there have been these levels of inflation in the past. This is why some economist argue that this can not be an initiating cause to the inflation. Cost-push inflation is another Keynesian version of inflation where it is shifts in aggregate supply, not aggregate demand, which cause the inflation.
Many different circumstances can lead to cost push inflation, the most common of these used to be wages being driven up excessive amounts by aggressive and powerful trade unions, this has not been such an issue recently due to the Thatcherite reforms in the 1980's. The cost of essential raw materials, particularly imported ones, cause cost-push inflation such as what happened in the 1970's when the price of oil rose dramatically. An increase in food prices caused by a bad harvest either in the UK or in the countries where we import most of our food.
A falling exchange rate will have the same effect as other countries raising the cost of their goods, they will become more expensive. This is particularly important in a country like the UK because it relies so heavily in imports of raw materials and foods. An increase in VAT will cause a once and for all rise in prices but this can lead to a wages spiral when they go up far too far. One of the main problems with this type of inflation is that it can lead to stagflation, this is where both prices and unemployment are rising at the same time and it can cause huge problems for an economy.