.. ts while keeping normal profit levels. ( See diagrams: Appendix 1) Another factor in the high level of inflation in the ’70’s – it reached almost 25% in ’75 (see appendix 2) – was the power of the Trade Unions. Because of closed shop practices, strike threats (and actual strikes; miners, Feb-Mar 1974) and an amenable Government, Trade Unions were able to increase the price of labour beyond proportional increases in productivity. It is the wage price spiral that is the most common feature of cost inflation: an increase in wages that is designed to compensate for an increase in prices will generate a further increase in prices, and in turn a further increase in wages, and so on.
Other types of cost push inflation are 1) those created by indirect taxes, but these will only result in a one time increase in inflation, as once prices have increased by the amount of the tax, there is no repeated shock to cause a spiral, and 2) currency devaluation – in 1967 British import prices were raised by around 15%, but, like taxation, it was a once and for all effect. Costs of Inflation Again, for costs there are two main categories of inflation; 1) Anticipated Inflation – this is inflation which is predictable, and hence damage limitation can be exercised to some extent, restricting the costs. ? Shoe Leather costs – these are incurred when prices are unstable. There is an increase in search time as people try to discover more about prices. Inflation also increases the opportunity cost of holding money, so people make more visits to their banks and building societies, so wearing out their shoe leather. ? Menu Costs – these are the costs to firms of re-publishing their prices every time there is a definite price increase.
They can be particularly damaging to firms who rely on catalogues to send bulky price information to customers. ? The costs of an imperfectly indexed tax system: if tax thresholds are not changed as nominal wages rise, people who were previously just below the boundaries could actually end up being taxed more than when they were earning less (nominally). ? Front end loading – this is the cost of servicing nominal debt contracts. 2) Unanticipated inflation – with this the costs can be much higher. They are as follows: ? Redistribution costs between borrowers and lenders.
This redistribution occurs when the real rate of inflation exceeds the real rate of interest, so people who have borrowed money can actually end up paying back less than the value they borrowed. ? Distortionary effects 1) Confusions between relative and average price levels 2) Discouraging long term investment projects – if there is too much uncertainty over future rates of interest and inflation, cost benefit analysis cannot be applied to future projects and investments, returns cannot be calculated so less investment takes place. 3) Savers and Lenders may demand a risk premium – if they recognise the problem of redistribution costs, they will want to increase their interest rates to allow for this. 4) Savers and investors may form different expectations of inflation, possibly resulting in a misallocation of capital: if an entrepreneur with a safe project approaches an investor who thinks the future is risky, he may be offered a rate of interest that is too high for him to make sufficient profit, and so the project will be shelved. However, if an entrepreneur with a risky project approaches an investor who thinks the future safe, he will be offered a more affordable rate of interest than if inflation was stable – and hence a misallocation of capital results.
Costs to UK The costs to the UK of the inflationary spiral of the 70’s Oil crises were: inflation of 13.4% in 1979, rising to 18% in 1980. The Government tried to counter this with medium term (4 year) financial strategy targets, focused on tightening the supply of M3 (notes and cash in circulation, plus bank deposits) but because a high proportion of M3 is interest bearing, high interest rates induced people to hold more of it, hence a decline in M3 velocity. Monetary growth collapsed. The strength of sterling at the time, coupled with the high North Sea oil prices, meant a massive erosion of UK competitiveness, and this, together with the crash in monetary growth led to a UK recession. Unemployment started at 8% in 1981 and reached almost 12% (claimant count see appendices) by 1986. The specific costs to the UK of the Lawson Boom were very similar – recession and unemployment.
In 1986 there was a dramatic fall in oil prices, back down to almost mid 1970’s levels. This acted in the same way as a cut in and indirect tax would – price decreased and demand increased, and estimations of it’s impact on the economy were as high as a reflation of between 2 and 2.5 % GDP. In 1987 sterling declined in real terms by 15%, which meant increased UK competitiveness abroad, and so more demand for UK goods and services. This, combined with financial sector deregulation and innovation led to a consumption boom. Exchange rate policy at the time was to shadow the Deutschmark, but as the pound was under upward pressure, interest cuts had be made.
As far as domestic demand was concerned, this was a bad decision, as it further aggravated the problem of inflation. The expansion in demand became obvious, and so base rates were increased from a low of 7.5% in 1988 to a high of 15% in late 1989 Because consumer demand had been initially slow to respond, interest rates went too high, and by the time they were reduced in October of 1990, the country was starting to enter a recession: household disposable income was actually negative during 1991, which means that consumer spending must have been very low. Unemployment, as a lagged indicator of the state of the economy, didn’t catch up until later, but it peaked at around 10.5% in 1993. Conclusion The empirical evidence of the correlation between raising interest rates (contracting the money supply and reducing consumer expenditure and demand) and subsequent falls in inflation would seen to bear out the Quantity Theory of Money. The biggest costs to the UK from the inflation of the’70’s and ’80’s was unemployment through recession – it was the contractionary policies of the Government which brought about the slumps in consumption that cause unemployment. It is the Boom and Bust business cycle which has been a feature of market economies for so long: boom = inflation = high interest rates = bust.
It is what Margaret Thatcher tried to avoid with the creation of supply side policies to make the markets more responsive to increases and decreases in demand. The problem has been that costs of recession (ie unemployment) are lagged – they do not respond until after the damage has been done, and so, in the example of the Lawson Boom, because consumer demand did not respond swiftly to interest rate increases, rates were put up too much, which stifled growth instead of merely slowing it. Some people are now suggesting that the cycle of boom and bust has ended with the advent of e-commerce, as more and more firms employ increasingly fewer people, and are far more responsive to changes in demand. There is some empirical evidence to suggest this as inflation seems to have been fairly constant for the last few years (see appendix 2). However, whether this is due to e-commerce, the Bank of England having semi-autonomous control over interest rates, or some other factor, has yet to be seen. Economics.