Eco Today - Mar10:ET Master Page 2007 - ASKnLearn

Key words
Gross domestic product
Deflation
Output gap
Aggregate demand and supply
Commodity prices
The Prospect Ahead:
Deflation or Inflation
Quintin Brewer, a Chief Examiner and teacher at North London Collegiate School,
considers a data response question concerning the prospects for deflation or inflation.
A
s the UK and world economy moves out of recession and into recovery in
2010, there is discussion about whether there is a danger of deflation or a
likelihood of inflation. Obviously, this has important implications for monetary
policy, in terms of decisions made by the Bank of England’s Monetary Policy
Committee with regard to both interest rates and its policy of quantitative easing.
Much of this is highly topical and you should remember that examiners are always
impressed by those candidates whose responses reflect understanding of current
economic issues together with an ability to apply relevant economic theory in
discussing them.
N.B. Although much of the material is relevant to AS, some of the answers would only be covered in your A2 course.
Extract 1: The danger of deflation
Reduced spending by consumers and an extended period of high unemployment mean that there is likely to be a continuation
of the negative output gap (see Figure 1). In the USA that gap has been estimated to be between 8% and 10% while in the
UK, it has been estimated to be over 3%. This is likely to result in significant competition for sales and for jobs and so place
a downward pressure on prices. In the UK’s case the output
Figure 1: The output gap and unemployment in the UK
gap is bigger than in the recessions of 1981 or 1991 which led
10.0
to inflation falling by more than six percentage points. A
repetition of these experiences would result in deep deflation.
7.5
It will take a considerable time to absorb the enormous
surplus labour and production capacity created by the most
severe recession since the 1930s. Wage rate growth has been
subdued and there has been a decline in the average hours
worked. Until production and employment grow enough to
push up wages the most serious concern will be deflation
5.0
% 2.5
0
Unemployment
rather than inflation.
-2.5
In conclusion, the consensus view is that there is much
Output Gap
slack in the economy. With factories facing lower orders,
-5.0
producers will not raise prices and workers will not demand
’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12
higher wages.
Source: tutor2u.net Unemployment – claimant count measure
Extract 2: The threat of inflation
There are several reasons for questioning the view that deflation is a real danger, the first of which is that the authorities
slashed interest rates to 0.5% in March 2009 (see Figure 2) while also embarking on a programme of quantitative easing
which effectively increases the money supply.
Secondly, the UK’s fiscal deficit is heading for nearly 13% of
GDP and the national debt is increasing at an alarming rate.
Several other factors also suggest that inflation might be a
problem in the future.
Thirdly, rising commodity prices in 2009 coupled with the
weakness of sterling have increased inflationary pressures.
Fourthly, UK inflation is increasingly affected by international
inflation so the UK’s output gap is less significant than the
global output gap. The rapid recovery in other economies,
especially those in emerging markets and in developing
countries, implies that the global output gap is falling even if
the output gap in the UK is not.
A further factor is that the surplus labour implied by the
increase in unemployment may not result in falling wages
because those out of work tend to be younger and less
experienced than those with jobs.
Figure 2: Bank of England interest rates, Aug 2008-Jan 2010
%
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0
Aug
’08
Oct
’08
Source: tutor2u.net
Dec
’08
Feb
’09
Apr
’09
Jun
’09
Aug
’09
Oct
’09
Unemployment – claimant count measure
Dec
’09
Feb
’10
M ARCH 2010 27