The aim of this report is to provide information, measures and suggestions to the Chancellor of the Exchequer on what and how to deal with the inflation in UK

Inflation in United Kingdom

Inflation is the process of making addition to currencies not basedon a commensurate increase in the production of goods.

-Federal Reserve Bulletin (1919)

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Executive Summary

The aim of this report is to provide information, measures and suggestions to the Chancellor of the Exchequer on what and how to deal with the turmoil of inflation in recent days in the United Kingdom.

In this report we define inflation and describe type of inflation, cause of high rates of inflation and explain the measures taken by the United Kingdom to overcome it. We will analyze the "Costs and prices", including those of oil, food, wage increase and other commodities. These commodities have now resulted in unanticipated rise of inflation because of high demand and their low supply. In accordance with the recent surveys, In England, the Consumers price index has increased from 2.1% in December 2007 to 4.7%

Figure 1

Figure 2

Figure 3

in August 2008 which is above targeted inflation of 2%.

Measures to control inflation can be increasing the interest rates which results in reduction of currency in circulation but its consequences can be a threat to deflation and credit crunch. Therefore, to overcome this other measures which are fiscal policy are suggested; these includes appreciation of exchange rate, income policy, supply side policy and expectation of inflation which could be used to control inflation both in short term and long term.

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Table of Contents

Item Page

iExecutive Summary �

11. Introduction �

22. Inflation definitions �

33. Causes for inflation �

33.1 Costs and prices. �

3.1.1 Oil Price 3

43.1.2 Food Price �

43.1.3 Wage Increase and Unemployment �

53.1.4 Other commodities �

4. Controlling inflation 5

4.1 Monetary policy 5

4.2 Fiscal Policy 6

4.2.1 Increase direct taxes 6

74.2.2 Decrease Government spending �

4.3 An appreciation of the exchange rate 7

4.4 Income policy 7

4.5 Long-term policies to control inflation 8

84.5.1 Increase direct taxes �

4.5.2 Reformation of Supply-side 8

94.6 Expectations of inflation �

105 Discussion and conclusion �

6 Bibliography 11

7. List of Figures 13

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Introduction

Aims of the report

The aim of this report is to provide measures and suggestions for the Chancellor of the Exchequer about how to cope with the price rises in recent days in United Kingdom.

Objectives

The report sets out to achieve the following objectives:

Define inflation and related terms

Clarify the causes of the current higher rates of inflation in UK

Present the feasible measures for controlling the UK's inflation

Methodology

For the purpose of achieving the above objectives, the report will make full use of relevant website articles, academic materials, economic journals and relevant statistics and reports.

Intention

The report intends to achieve a solution to how Bank of England (especially the MPC) does respond to the high rates of inflation beyond the inflation target at the beginning of the great recession.

Background

UK inflation has risen unexpectedly since at least 1997 in May, and Bank of England Governor Mervyn King predicted it will exceed 4% later this year, adding to speculation that the economy will fall into a recession (BusinessDay, 2008). In England the Consumers price index has increased from 2.1% in December 2007 to 4.7% in August 2008 far away from targeted inflation of 2 percent (King, M. 2008).

Inflation definitions

INFLATION is defined as "a sustained increase in the general level of prices over several successive quarters of measurement"; it is a rising general level of prices (Master, 2008).

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time (Michael B et al., 1997), the term "inflation" once referred to increases in the money supply monetary inflation; however, economic debates about the relationship between money supply and price levels have led to its primary use today in describing price inflation (Michael, 1997). Inflation can also be described as a decline in the real value of money-a loss of purchasing power (Central Bank of Iceland, 2008). When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of price inflation is the inflation rate, which is the percentage change in a price index over time (Mankiw, 2002).

Measuring inflation: Increase in the overall price level of an economy, usually as measured by the CPI (Consumer Prices Index) or by the implicit price deflator.

From the view point of economics: the general inflation could be classified into 2 types:

Demand-Pull Inflation: This inflation occurs when the government / consumers / business try to purchase more output than the economy is capable of producing.

Cost-Push Inflation: This inflation is inflation due to decreases in supply, primarily due to increases in production cost

Inflation target in UK:

The operational target for monetary policy is an underlying inflation rate (measured by the 12-month increase in the CPI) of 2%. The inflation target is 2% at all times; it is the rate which the MPC is required to achieve and for which it is accountable' (HM TREASURY, 2003 p.3)

The Monetary Policy Committee "is concerned about the present and prospective period of above -target inflation". According to the National Statistics, the consumer prices jumped to 4.7% which is more than twice the usual rate. The path of bank rate that will be necessary to meet the 2% target is uncertain (BusinessDay, 2008 p.1).

Causes for inflation

The current inflation in the UK and US is being driven higher by increase in the prices of energy, raw materials and basic foodstuffs. Costs of running the government has also contributed substantially in the inflation in the UK. These economies have bigger problem from the way credit has dried up, leading to job losses in the US and sharp slowdown in the UK economic forecasts (Redwood, 2008).

It is anticipated that price inflation worldwide will increase this year due to imbalance of demand and supply. In England the Consumers price index has increased from 2.1 percent in December 2007 to 4.7 percent in August 2008 higher than the targeted inflation of 2% (King, 2008). Higher rate of inflation is generally caused by the increase of the credit and money supply that exceed production at a certain period of time. This is due to low production which result in high demand and this led to increase in prices. These are the considered main causes of inflation in the rest of the world.

In August 2008, oil prices went up 60% higher than a year earlier, wholesale gas prices were up 90%, and food prices 40% (Gieve, 2008), see Figure: 1-4.

3.1 Costs and prices.

The rise of prices of food, oil and other commodities has resulted in the rise of inflation. This is because the demand has extended while the supply is minimized. There is an excess increase of Energy prices especially gas and electricity and these has increased the domestic spending and makes the overall inflation higher (BBC, 2008a). The domestic energy bills has increased, people spend most of their income in bills. There is no access in borrowing in banks and other lending institutions since the banks have tightened the credit conditions.

Here in United Kingdom they have led to large increase in the retail prices of food, petrol, gas and electricity. In the year to August:

Food prices in the shops rose by 13 percent

Petrol prices rose by around 20 percent and

Retail gas and electricity prices rose by around 25 percent. (King, 2008, p.2).

The undervalued of UK sterling caused the import price to rise and affected the rise of prices in markets

Oil Price

'According to the inflation of the late 1970s in the US was largely attributable to increases in oil prices, from $5.21 per barrel in 1973 to $35.15 per barrel in 1981.This is turn contributed to inflation rising from 3 percent in 1972 to 18 percent in the first quarter of 1980' (Guell, 2007).

The oil production has reduced and demand is increasing day by day both in the UK and overseas. Demand from the big, rapidly growing economies of China and India has been, and likely to remain the major reason for higher oil prices' (Wyss et al., 2008, p.2). From last year's data China was estimated to consume around 3.2 million barrels for just one day. By this year they are expected to import 400,000 b/d for use.

Oil prices have nearly doubled compared to last year's price which was 70$ a barrel and by August 2008 the price was over 138$ a barrel (BBC, 2008b).

Increase of oil price has made a decline in business sectors as costs of shipment and production in industries has been affected by the increase of price of this important source of energy. Aircraft industries are also highly affected both from parts production up to the transportation sector.

Food Price

Higher food prices are also a major cause of inflation and have slowed the personal income since food is the highest domestic demand. This starts from the farmers particularly those who plant corn and take advantage on increase on the prices of oil and the current trend of scaling up of agro fuels. Corn grains is food to human and mainly used to make animal feeds, thus, its shortage results into high price, which entirely also inflate prices of other commodities which depends directly or indirectly to the corns such as the price of all kinds of meat, dairy and eggs (Wyss et al., 2008). People are running for a better nutrition diets which consists of meat and poultry, this demand switch to an increase of the meat price.

Wage Increase and Unemployment

The increase of wages slows the industrial sectors. The industries had to prune the number of employees to cover the cost incurred from raw materials and energy. The outputs are reduced and as there is increase in demand the output prices rise. Consumers and foreigner investors faces difficulties to pursue their business in high price and there is delay in demand.

There is a downfall of a number of manufacturing jobs in UK, where by it has reached 2.86 million; this being the lowest number since 1978 records. There is a huge number of unemployment which is 5.8% in rate and it is also the highest rate since 2000. Many people are looking for jobs others have already faced redundancies, and at the current situation there is no vacancies as the companies need to recover the operating costs (BBC, 2008c).The minority are at work although they never enjoy their income due to the rising cost of living. Vacancies were down by 40,000 according to the Office for National Statistics' (BBC, 2008b).

Other commodities

The commodity prices have generally risen due to the unexpected rapid expansion of the biggest emerging market economies in the first half of 2008. Therefore this has generated a wide difference within the demand and the supply of these commodities.

The high demand of metal from China and India has also caused the increase of metal price. Most of the metal shipment is to India and China where there is a rapid economy growth. Their excessive demand made unbalance in demand and supply which resulted in the price rise. The automaker Industries face difficult environment of high price and metal scarcity which slows production in motor vehicles and other related parts (Wyss et al., 2008).

Controlling inflation

The purpose of controlling inflation is to return inflation back to the 2% target rather than completely eliminate the inflation to draw a deflation.

Monetary policy

The government's central economic policy like the monetary policy is to achieve high and stable levels of growth and employment (HM TREASURY, 2003, p.5). Monetary policy should be used to meet the objective of low rates of inflation, since low and stable rates of inflation are conducive to healthy growth rates (Arestis et al., 2005). 'Inflation is ultimately determined by the pressure of the money spending on capacity, which is controlled by monetary policy' (King, 2008, p.1).

Increase the interest rate

The inflation which is caused by an excess of purchasing power, to some extent, could be adjusted by increasing the interest rate. In other words, the supply of money hugely exceeds to the goods and services in the market. Generally, the government will battle the high prices rises by means of affecting the interest rates.

The interest rates higher, it will discourage UK borrowers and companies to make a loan from banks. So the same effect will also happen to the mortgage payments, the homeowners have to pay extra mortgage interest payments than before. It indirectly reduces the demand in real estate market. The higher interest rate will make investors in UK not to invest at this time due to the high interest rate. If there is an increase in real interest rate, it will reduce the demand for lending.

In the recent inflationary phenomenon, price rises in August in UK are mainly caused by the external factors such as the supply of the oil. To be more specific, the current inflation in UK is not like the inflation in China or other countries with a high growth rate of GDP. So MPC using the monetary policy via increasing the interest rate could not effectively control the current situation in UK without combing with other measures. What is worse, although there is inflation in United Kingdom, all other evidences indicate that there will be a deflation. So increasing the interest rate in UK might not be a long-term way to achieve the goal of price stability. Because the liquidity in the UK's financial system has been dried up on account of the credit crunch. Therefore, the situation is abnormal. In view of the exchange rate, the pound in UK is being depreciated and there will be a deflation owing to the credit crunch. There will be a big challenge for UK to overcome this coming great recession.

Fiscal Policy

Mishkin (2000) argues that "Restraining the fiscal authorities from engaging in excessive deficits financing thus aligns fiscal policy with monetary policy and makes it easier for the monetary authorities to keep inflation under control"(P.2). It is thereby suggested that within this framework, "monetary policy moves first and dominates, forcing fiscal policy to align with monetary policy" (Ibid., P.4).

Increase direct taxes

A curtain public expenditure along is not sufficient. Government must increase taxes to reduce private expenditure also in order to minimize inflationary pressures. Generally, when more taxes are imposed, the size of the disposable income diminishes, as also the magnitude of the inflationary gap, given the available supply of goods and services (Rai Universtiy, n.d., p.71).Although there is a debate about whether the tax policy is a correct measure to cope with the inflation, a progressive direct tax is considered feasible.

Decrease Government spending

According to the (Guell, 2007), the increase of Government spending or taxes decrease then there will be an aggregate demand increase and demand-pull inflation occurs.

For example, in US, government spending was increasing rapidly, inflation increased from 1 percent in 1965 to 6 percent in 1970. (Guell, 2007, p.101) To control the demand-pull inflation, we should have a lower government spending.

In the UK everything points to the need to cut the costs of government, not by reducing the quality of services that matter but by improving the services where they need so. The government has done the right thing in at last telling the public sector - including Mps - that this year's pay rise has to be below inflation (Redwood, 2008).

An appreciation of the exchange rate

In order to control the inflation in UK, we assume that if there is an appreciation in the UK pound, it will increase the expense on the exports of UK and will make it hard to export products to other countries due to the higher price. That is to say, the UK companies have to save the costs for the purpose of being survived in the competitive market. Meanwhile, the import prices decreases. And this will make the cost of the companies to be lower.

If the there is an increase in the value of exchange rate will result in rising in interest rates. In this way, an appreciation of the exchange rate could also be used as a method to control the inflation.

Income policy

Direct wage controls could be used as a tool for restricting the growth of wages and it could also have the capacity to decrease cost inflation. Since 1970s, the UK government utilized this measure to limit the rising of the wage in public sector.

In another sector, the private sector, the policymakers should spare no effort to persuade employees to be self-control in wage negotiation. In view of the start of the recession in UK's economy owing to the current financial crisis around world, then the wage inflation begin to reduce. These factors may lead the employees to call for an employment protection due to the lower wage.

Long-term policies to control inflation

To get long term price stability, there must be Government policies which would have future focus on inflation and help in economy growth"a precondition for high and stable levels of growth and employment"(King, 2008).

Increase direct taxes

To control the cost-push inflation, companies should save their labor costs by accelerating the flexibility in the labor market. On one hand, they could impair the trade union power. On the other hand, more and more people are getting involved in the part-time jobs. These factors do enhance the flexibility in the labor market.

Reformation of Supply-side

If the companies in UK produce more products with a relative lower cost as it was before, the above-target inflation will go back to 2% in the UK's economy. A vital long term objective of governmental policy in economy is the increase in the aggregate supply.

In the long run, the objective of the reformation of supply-side is to increase the capital productivity. With the development of productivity, the labor costs have been saved considerably. Therefore, it is unlikely that the price of products will rise.

In order to control UK's inflation in the long run, the policymakers in UK should not only concern the aggregate demand by means of the fiscal and monetary policy but also reform the supply side to strength the productivity and reduce the costs of products.

Expectations of inflation

Research evidences from surveys and financial markets shows that higher rates of inflation have increased expectations of inflation (King, 2008, p.3). According to Gieve (2008, p.2), to get inflation back to the 2% target and thus influences the expectations of financial markets, price setters, wage negotiators and households generally. And expectations themselves have an important impact on inflation. The inflations of the 70s to early 90s that raising interest rates will in time bring inflation down, even when expectations of future inflation are high. However, the situation is really complicated due to the credit crunch. There has been insufficient and unsecured lending in banks which has resulted in shortage of credit. This credit crisis has brought losses in many banks and therefore the banks had to introduce tighter lending and credit conditions so as to rescue the business. These credit conditions has reduced the output in the economy that is there is no a relative output of goods and services. The income has been squeezed and on the other hand the income is been spent in high food and energy prices, therefore there is this threat of credit crisis. It is wise for people to have a different thought and behavior towards the inflation. The more confident people are that inflation will fall back the less we have to rely on slowing the economy to force them to hold prices and wages down.

Discussion and conclusion

Inflation is a rise of a general level of prices of goods and services in an economy at a certain period of time. That is the excess in money supply which increases prices and in general we call price inflation. The higher rate of inflation is caused by the increase of credit and money supply that exceed production. Unexpected expansion of the large emerging market economies has attracted the excess demand for raw materials and pulled the price up.

The price rise of food, oil and other commodities are the immediate driver of that increase. The increase of energy prices, gas and electricity price also is a major cause of inflation. Oil prices has nearly doubled compared to last year's price which was 70$ a barrel to 138$ a barrel in August 2008. Food price has increased as food is the major domestic demand. The increase of wages and the rise of the price of raw materials including metal have contributed to the rise of output price from the industries, as to cover the operating costs. This has also contributed to the huge number of unemployment.

The main objective of the monetary policy is to control inflation back from 4.7 percent to 2 percent target. Steps must be taken to avoid this turmoil and care must be taken to avoid any risks to result from those steps like carelessness might put the Government into deficit. Economic stability is to be maintained so as to reduce fear on citizens, business and foreign investors. The raising of interest rate is mostly expected to be a major tool of controlling inflation; this raise will reduce the excess supply of money. But it is also a great enemy of everybody's life. It increases fear on increase of unemployment and bankruptcy. The effect of inflation always starts in homes where the rise of wages affects people's employment and the rise of commodity prices affects the domestic economy. Government must increase taxes to reduce private expenditure which will therefore minimize inflationary pressure. The decrease of Government spending will make the aggregate demand to slow down; therefore this will help in controlling the high rate of inflation. An appreciation of the exchange rate is another tool to control inflation. When there is appreciation in UK pound the cost of exportation will increase due to increase in price and importation cost will decrease thus the overall cost of the companies will be low. Direct wage control helps in restricting the growth of wages and when the wages are controlled then the high inflation is controlled.

There are also long term policies to control inflation which includes the reformation of labor market and of the supply side. Companies should save their labor costs by accelerating the flexibility in the labor market. The reformation of the supply side is to increase the capital productivity. The companies in UK should produce more goods with a relatively low cost then there will be an increase in supply and decrease in the output price.

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6 Bibliography

BBC (2008a) Consumer inflation reaches 5.2, changing habits [WWW] BBC business news home page. Available from: http://news.bbc.co.uk/2/hi/business/7668608.stm [Accessed on 14th November, 2008].

BBC (2008b) Consumer inflation 'could top 4%.Economic slow down.[WWW] BBC business news home page. Available from: http://news.bbc.co.uk/2/hi/business/7458209.stm [Accessed on 14th November , 2008].

BBC (2008c) Unemployment reaches 11-year high [WWW] BBC business news home page. Available from:

http://news.bbc.co.uk/2/hi/business/7724084.stm [Accessed on 14th November ,2008].

BusinessDay (2008) UK inflation at decade-high.p.1 [WWW] BusinessDay. Available from: http://business.smh.com.au/business/world-business/uk-inflation-at-decadehigh-20080618-2ser.html [Accessed on 22th November, 2008].

Central Bank of Iceland (2002) "Why price stability?" [Online] Central Bank of Iceland. Available from: http://www.sedlabanki.is/?PageID=195 [Accessed on 10th November, 2008].

David W., Robert M. and Frank E. Benassi, (2008) The turmoil from high commodity prices, What's driving up oil prices?, p.2, Standard and poor's ratingsdirect, [WWW] published in Business Week online. Available from: http://www.businessweek.com/investor/content/apr2008/pi20080421_773956.htm [Accessed on 14th November, 2008].

Gieve, J. (2008) "John Gieve: The credit crunch and the UK economy (Central Bank Articles and Speeches)" .p.2 [WWW] Bank for International Settlements. Available from: http://www.bis.org/review/r080924e.pdf [Accessed on 22th November, 2008].

Guell,R C. (2007) Issues in Economics Today. 3rd ed., New York: McGraw-Hill.p.101

HM TREASURY (2003) Remit for the Monetary Policy Committee of the Bank of England and the New Inflation Target.p3-5 [Online] Bank of England. Available from: http://www.bankofengland.co.uk/publications/minutes/mpc/pdf/2004/remitletter2004.pdf [Accessed 25th November, 2008]

King, M. (2008) Letter from the Governor to chancellor.p2-3 [WWW] Bank of England 15th sept 2008. Available from:

http://www.bankofengland.co.uk/monetarypolicy/pdf/cpiletter080915.pdf [Accessed on 14th November, 2008].

Mankiw N. Gregory (2002) Macroeconomics 5th ed., Worth. New York: Worth Publishers.p.22-32

Michael, B. and Charles, W. (1997) Macroeconomics: A European text, 2nd ed., p. 579 (Glossary). ISBN 0-19-877468-0 See also: Olivier, B. (2000) Macroeconomics, 2nd ed., Glossary. ISBN 013013306X and Rober,t B. (1993) Macroeconomics, 4th ed., Glossary. See also: Andrew, A. and Ben, B. (1995), Macroeconomics, 2nd ed., Glossary. ISBN 0201543923.

Master, C. (2008) Economics, Inflation and the Ruse of the CPI [Online] Edison's Light Bulb. Inflation and the Ruse of the CPI . Available from: http://www.nolanchart.com/article5285.html [Accessed 16th November, 2008]

Michael F. Bryan (1997) Economic Commentary, On the Origin and Evolution of the Word 'Inflation [WWW] Federal Reserve Bank of Cleveland. Available from:http://www.clevelandfed.org//research/commentary/1997/1015.pdf [Accessed 8th November , 2008].

Mishkin,F.S. (2000). "what should Central Banks Do?" Federal Reserve Bank of St. Louis Revew. 82(6).PP1-13.

Rai University (n.d.) Lecture Material. "Lesson 12: Control of Inflation" p.71 [WWW] Rai University. Available from:http://www.rocw.raifoundation.org/management/bba/BusinessEconomics-II/lecture-notes/lecture-12.pdf [Accessed on 22nd November, 2008].

Redwood J. (2008) "Inflation in a credit crunch- high interest rates will make the crunch worse" p.1 [WWW] John Redwood Blog. Available from: http://www.johnredwoodsdiary.com/2008/03/10/inflation-in-a-credit-crunch-high-interest-rates-will-make-the-crunch-worse/ [Accessed on 22th November 2008].

7. List of Figures

Figure 1: UK- Infalation indices - CPI, RPI

Figure 2: Wholesale gas and domestic energy prices

Figure 4: Energy prices