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Consistency of inflation

The unemployment record in the UK became substantially worse at the beginning of 1970 mostly because of the oil-price shocks, moreover, the Philips relationships between unemployment and inflation, that had been there for more than 100 years, fell apart. There may also have been some strengthening of the wage‑price spiral then as the result of an increased sensitivity of wages to prices. In the early 1970s, the main exogenous disturbances were the 'wage explosions' of 1970 and 1972, when wages rose much faster than could be attributed to their normal relationship with prices. The 1970 explosion may have been a 'catch‑up' from the prices and incomes' policy, that had kept the wage rises under control and was now abandoned. 1972 rise seems to be attributable to direct union push associated with discontent over the Industrial Relations Act of 1971 and the policies of the Conservative government. The sharp rise in the numbers involved in industrial disputes, as shown in the graph, bears witness to this explanation.

Between 1972 and 1975 the most important factor was the colossal rise in oil and other import prices. The increase of 112% in import prices must, with imports comprising 22% of total final expenditure (TFE), have added well over 20% to the level of retail prices. The raw materials of non-oil manufacturers went much more expensive. Inflation was also helped by Heath government's too liberal incomes' policy.

Demand pressures also became important in 1973-74. Demand pressure is basically the phenomena according to which the excess demand makes the prices of products and wages to increase, whereas wages and prices are downward sticky when there is excess of supply. Demand pressure on wage side can be measured by the unemployment rate (Philips curve), but the more accurate measure is the vacancy rate as this shows the actual demand for labour. However these two measures moved very closely until the middle of 20th century and then started to deviate. Also as seen from the graph the simple correlation is very bad between RPI and vacancy rate. It is partly attributable to the fact that simple correlation is not the measure to use here (log correlation or lagged correlation might be more appropriate). More serious problem is the reporting of vacancies. It is estimated to be only about 1/3 of the actual vacancies. However if this proportion was to remain stable we could still use the vacancy rate, but some studies have suggested it has fallen. Anyway the number of vacancies has followed a "more correct" route compares to inflation after the Philips curve relation has broken down.

High rates of monetary expansion and low real rates of interest helped to raise the pressure of demand to unprecedented levels in 1973-4, but was not the sole cause of the inflation. Money supply increase is the other major variable thought to affect inflation form a simple quantity theory equation MV=PT, where V and T are exogenous and can thus be regarded as constants. However there is a problem of causation in here, money supply can just rise to accommodate the inflation. Also as we later see the velocity tends to be highly volatile and correlates with inflation making the assumption about its exogenouty doubtful.

After 1975 there was a sharp decline in the inflation rate for three years, and by 1978 the rate had fallen 16 points to 8%. This decline was partly attributable to the lower pressure of demand in 1976 and 1977, but the main factor responsible was the introduction in July 1975 of an incomes' policy that won the consent of the trade union movement. The rise in the inflation rate between 1978 and 1980 can be traced to a number of influences, of which the first was the revival of demand pressure in 1978 and 1979. Oil prices rose sharply between 1978 and 1980, with the OPEC price more than doubling between these years. A more serious factor, however, was the withdrawal of union co‑operation with incomes' policy and the wage increases associated with the 1978‑9 'winter of discontent'. VAT rate was also increased. It is an indirect tax and thus raises prices. It is thought to be unrepresentative of real market situations to include VAT in RPI, so there is now an index without it. Similarly mortgage interest rate is excluded from RPI as otherwise paradox had risen whereby government action to decrease inflation by rising mortgage interest rate was actually increasing it.

It is also thought that the change in exchange rate of 4% will change inflation by 1% so called import of inflation. However there is not much evidence on that, but the international aspect cannot be ignored of course. Changes in world prices might be a better estimate.

During the 1980s the inflation rate subsided from that of the seventies, and in all other respects followed the principle that the demand pressure (measured by the vacancy figures) was the principal determinant of wage changes, and through them of price changes. Between 1980 and 1986 the inflation rate fell by 15 percentage points, although the decline would have been less without the VAT increase. World primary product prices were falling at this time (in dollars), but UK import prices (in sterling) rose each year at a fairly steady 8­-10% and were not a cause of the lowered inflation rate. The cause of the reduced rate of inflation in this period, primarily internal, was the low pressure of demand and the low vacancy rate. The figures for industrial disputes also show a marked reduction over this period.

After 1986, the rate of inflation was creeping up again, mainly because of the gradual rise in the pressure of demand for labour making earnings and profits to rise. The recession that followed brought a sharp reduction in the pressure of demand ­almost as sharp as in 1981 ‑ with a consequent reduction in the growth of money earnings and retail prices. The rise in import prices was also abating during this period.

Money supply targets were abandoned because it was hard to define money supply, either narrow or sharp could be used. Inflation started to increase again leading to a peak in 1989. That was mainly because of the general boom in economy - reaching to supply side constraints and the major boom in the housing market. Trade union influences had diminished mainly because of the falling membership and legislation introduced in 1985 that made a secret ballot before strikes compulsory, signalling the employer to start negotiating. Housing boom was ended by the sharp rise in interest rates by the Bank that caused a slump in the housing market. Fluctuations in price caused by the exchange rate were eliminated because the exchange rate mechanism was in operation.

Capacity utilisation is also a determinant of inflation. In boom years the investment has to be increased substantially, moreover, as the firm reaches its limits of production more breakdowns will occur and the average cost will get higher.

It is still very hard to predict the actual inflation because the government is trying to keep it low. Of course this (as seen from the graph) crashes with the other objective, low unemployment. Still government can through its monetary policy and budget influence inflation indirectly (contrasted by direct influence of incomes' policy). This appears to be more successful when the government announces low inflation as its primary target as then expectations about inflation are set accordingly. The policy changes are obviously very hard to predict and government might also pursuit inflationary policies when it needs to lower taxes to gain popularity and thus PSBR increases or when it is faced with balance of payments' problems. Expectations about the future inflation rate thus play a major part. In fact the inflation year ago correlates quite remarkably to present inflation. Much work is done on expectations nowadays.

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