This is a very good video on inflation from The Economist – it discusses why over the past two decades inflation has remained low in good times and bad. There is a brief look at historical rates of inflation and policy with reference to Bill Phillips (Phillips Curve) and Paul Volker (US Fed Chairman) who increased the prime interest rate to 21.5% in 1981 to tackle inflation. Also low interest rates and government fiscal stimulus could start to see an upward movement in the inflation figure. Very useful for Unit 4 of the CIE AS and A2 Economics course.
This post refers to Unit 4 of the CIE A2 Economics course. Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:
M x V = P x T
M = Stock of money
V = Income Velocity of Circulation
P = Average Price level
T = Volume of Transactions or Output
For example if M=100 V=5 P=2 T=250. Therefore MV=PT – 100×5 = 2×250
Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. To turn the equation into a theory, monetarists assume that V and T are constant, not being affected by changes in the money supply, so that a change
in the money supply causes an equal percentage change in the price level.
The speed at with which money goes around the circular flow is a significant indicator as to the economic activity of an economy. Money’s “velocity” is calculated by dividing a country’s quarterly GDP by its money stock that quarter – the bigger GDP is relative to the money supply, the higher the velocity.
Recessions – dampen the velocity by increasing the attractive of a store of value. People tend to save rather than spend. E.G. The Great Depression and the GFC. See graph for US velocity of money.
Covid-19 – with the closure of a lot of businesses and people worried about job security personal savings increased to 33.6% of disposable income. Also consumers didn’t have the money to spend.
The stimulus measures and the glut of dollars could cause problems once the consumer confidence starts to become prevalent. Inflation will inevitably rise again – which is not a bad thing considering the threat of deflation that we are currently experiencing. But the major concern is if the increase in spending spirals out of control with high inflation. It seems that central banks want the velocity of money to increase to kick-start the economy but they will need to consider how to control it if it gets above the ‘speed limit’. “You can’t have your cake and eat it”.
Source: Why money is changing hands much less frequently – The Economist 21-11-20
Below is a useful flow diagram from the ANZ bank which adds Large Scale Asset Purchases (LSAP) and Funding for Lending Programme (FLP) to the Official Cash Rate (OCR – Base Rate)
LSAP – this is the buying of up $100 billion of government bonds – quantitative easing
FLP – this gives banks cheap lending based on the Official Cash Rate – could be about $28 billion based on take up
OCR – wholesale interest rate currently at 0.25%. Commercial banks borrow at 0.5% above OCR and can save at the Reserve Bank of New Zealand (RBNZ) at 1% below OCR.
With FLP and more LSAP this will mean lower lending rates and deposit rates. This should provide more stimulus in the economy and allay fears of future funding constraints making banks more confident about lending. Add to this a third stimulus – an OCR of 0.25%. The flow chart shows the impact that these three stimulus policies have on a variety of variables including – exchange rates – inflation -unemployment – consumer spending – investment – GDP. Very useful for a class discussion on the monetary policy mechanism.
This is a very good introductory video on inflation from Economics Explained. It explains Inflation, Hyperinflation, Stagflation, Fiscal Policy, Monetary Policy etc. Material covered is part of NCEA Level 2 – Inflation and CIE AS Level Unit 4.
The consumers price index (CPI), New Zealand’s best known measure of inflation, measures the rate of price change of goods and services purchased by households. The CPI consists of a basket of goods and services that represent purchases made by households. The goods and services in the basket, and their relative importance, are reviewed every three years to ensure the basket remains up to date.
There are about 649 goods and services included in the basket. They are classified into 11 groups:
- alcoholic beverages and tobacco
- clothing and footwear
- housing and household utilities
- household contents and services
- recreation and culture
- miscellaneous goods and services.
These groups are then broken down further into 45 subgroups and then into 107 classes. The CPI is reported each quarter down to the class level.
After a review in 2020 the following goods or services have been added and removed from the CPI
Items that have been included in the basket of goods
Items that have been removed in the basket of goods
The rise in house prices in New Zealand has been against all expectations. Four indicators tend to have the biggest impact on house prices:
Lower interest rates seem to be the main reason for the major increase in prices but there is fear amongst consumers if they don’t purchase a property now they will miss out on the market as prices start to escalate. With interest rates being predicted to remain low for till at least the end of next year it is likely that house prices will remain elevated with no major correction. However as with most housing markets there will become a time when over-zealous investors push prices to non-sustainable levels. If house price to income and rent ratios blow out then owning a house will simply become an untenable option for a greater proportion of the population. Ultimately, prices will then have to move. Below is a useful graph showing house prices in New Zealand since 1963 – generally on the up for the vast majority of the period.
Source: RESEARCH ECONOMY WATCH – BNZ 15th October 2020
Here are some revision notes on inflation and a diagram that I have found useful. As well as cost-push and demand-pull inflation remember:
In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.
Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.
Part of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College in London. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted. Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.
Central banks have found that inflation has been the pest it has been in the past – most countries inflation rates have been short of its target rate. After the GFC the level of unemployment rose and inflation was quite subdues. However, with the post GFC recovery unemployment began to fall whilst the inflation rate was still showing no signs of accelerating which went against the original Phillips Curve. A further problem was that imported goods and services in one country have little relevance on the wages in another and the low levels of unemployment tempted people back into the labour force who hadn’t been counted as unemployed. This is particularly the case in Japan.
When there is an increase in job numbers, with a boom period, inflation may also be slow to rise. Although firms tend to be reluctant to lower wages when the economic climate slows as it is harmful to staff morale. The same could be said in good times as wages tend not to rise that quickly.
For many businesses changing the price of their goods or services can be costly especially for a small increase in price. Therefore the change in the business cycle tends not to be reflected in price changes as there needs to be major swings before prices will move at all. Central bank policy tends to manipulate interest rates to maintain a stable inflation causing unemployment to move up or down – unemployment is what changes not inflation.
The problem that central banks face today is that to keep the phillips curve flat they need to be able to cut interest rates to stimulate growth when inflation threatens to become deflation. However there is little room for further easing with rates so low. Central banks will need to work with the government’s fiscal policy to stimulate growth and spend the money that the central bank’s create.
The inflation rate in New Zealand, as in many countries, is on a downward trajectory – it will take a lot of stimulus form the Reserve Bank to meet its policy target agreement of maintaining the CPI between 1-3%. Westpac have forecast a drop to 0.2% in 2021 and to remain below 1% until the middle of 2022. There have been some obvious reasons for less pressure on inflation:
- Demand for goods and services both in NZ and overseas has dropped significantly and tamed any inflation. Most notably there has been a major drop in oil prices.
- The use of ecommerce and, without the overheads of rents / staff, prices are often much lower than the high street.
- With zero net migration and as excess capacity in long term rental market prices haven’t moved. Add to this the Government’s rent freeze.
- A lack of tourist dollars has meant a shift inwards of the aggregate demand curve as exports of services fall – AD = C+I+G+(X-M).
- With people having the growing uncertainty of job security there has been little additional spending or borrowing with the threat of redundancy hanging over them.
- The wage subsidy has kept some companies afloat but there has been no room for wages increases/negotiations for such uncertain times. Therefore consumer spending has been limited compared to previous years.
Important to note that inflation figures that are quoted are usually on a yearly basis so it is the change in prices from today to this time last year. It will be interesting to see what state the economy will be in this time next year.
I have blogged on this area before but thought it useful with the current discussion around macroeconomic policy. How does Modern Monetary Theory differ from more mainstream monetary policy – see table below.