The Need for Stable Inflation - inflation is a macro economic term used to describe the general level of all prices of products and services over a given period of time. In the United Kingdom it is generally measured using the Consumer Price Index (CPI) and expressed as a percentage. It should not be confused with the Retail Price Index (RPI) measure of inflation, which excludes housing costs (which represent a major factor in influencing Gross Domestic Product). A rise in inflation results in a reduction in the value of money, which remains theoretically constant. Economists tend to agree that stable low inflation help to create an ideal environment in which entrepreneurial innovation and economic growth can be achieved. Conversely, inflation that rises or falls quickly and sharply, has tended to create mini booms and busts. These are are more difficult to control and predict, both by governments and small firms.
The History of UK Economic Policies - to understand the causes and effects of inflation on small firms, it is sensible to first understand the background around why government economic policies have changed over the last 50 years. This is because economic policies implemented by the Government of the day, directly impact the behaviour of small businesses, as well as the economic conditions in which they must thrive. During the 1950s and 60s, monetary policy involved tight banking regulations implemented by the Bank of England. This had the effect of preventing retail banks from behaving improperly. In particular, it protected the strength of the Pound by limiting the amount of sterling converted into foreign currencies. The importance of the City of London as a global financial centre and inward investment, was a top Government priority in the post-war years.
Following the move from fixed to floating exchange rates in 1971, rising oil prices and trade union wage disputes pushed up inflation to over 20%, crippling business and consumer confidence. This dramatic inflationary increase shifted government focus towards monetarist policies to try and control inflation, manipulating interest rates and softening restrictions on bank lending. By the 1980s, the supply of money in the economy was controlled using growth targets under the policy termed 'Medium Term Financial Strategy', in an attempt to control inflationary pressure. Similarly, in an attempt to stabilise the impact of foreign exchange volatility, the UK famously joined the doomed European Exchange Rate Mechanism (ERM) in 1990.
Inflation became the most important economic factor of National stability. Targets were set to control its growth of between 1% and 4%. In 1997, the Bank of England was given 'operational independence' by the newly elected Labour government, who devolved the responsibility for setting interest rates to a Monetary Policy Committee (MPC). The MPC's job is to set interest rates at a level which mean inflation occurs at 2.5%. Since then interest rates became the primary means of influencing the inflation rate.
The Main Causes of UK Inflation -in identifying the causes of inflation, economists look at the changing levels of demand and supply within the economy. For instance, during the 1990's inflation steadily rose due to the demand for property, global prosperity and foreign oil and gas prices increases. Economics can be incredibly complex and well established theories exist to help us understand and explain inflationary pressures. The main inflationary causes are as follows:-
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Demand Pull Inflation - this occurs when the rate of growth of Aggregate Demand increases, faster than the rate of growth in the Aggregate Supply, pushing up prices within the economy. Increases in demand can come from a range of different factors. Economists define Aggregate Demand as Consumer Expenditure plus Business Investment plus Government Expenditure plus exports minus Imports. Interventionist (Keynesian) policies are sometimes used by the Government to boost demand (such as tax cuts and increases in public sector spending projects). Classical or 'Free Market' (Monetarist) polices are sometimes employed by Governments to allow the market to decide its own demand equilibrium level, without interference.
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Cost Push Inflation - this occurs when the rate or (Supply) of firms costs rises faster than the rate of demand for goods supplied by those firms. For example, rising wage costs force firms to slowly rise prices, in order to sustain profitability. This occurs in the private sector when firms compete to try and recruit or retain staff by offering more money.In markets where little competition exist, prices tend to rise year on year (such as railways, banking and airports). In the public sector, above inflation union negotiated wage settlements also push up the overheads of firms. Another example is where firms rely on imported raw materials to produce products here in the UK. Firms buying imported materials from China have began to suffer from China's own inflation boom. Firms that rely on imported materials may also suffer from falls in the value of sterling, increasing their cost base.
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Increase in Money Supply (Quantity Theory of Money) - when the quantity or amount of money supply in the economy increases, inflation rises. The additional money within the economy has the effect of increasing the level of demand and hence increasing demand pull inflation.
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Price Expectations - if the population believes and expects inflation to rise in future, they will change their behaviour accordingly. Expected Inflation becomes a self-fulfilling prophecy. People tend to overreact (both positively and negatively), in the knowledge and expectation that good times or bad times lie ahead. For instance, lots of amateur landlords jumped on the buy to let boom band wagon in the hope of making a quick profit. This pushed up property prices further still. Conversely, when the economy looks like its slipping into recession, business leaders massively cut back on non essential long term investment, fearful of falling orders and having to make employees redundant. Where as in good times, speculators tend to borrow heavily in order to finance investments in high-growth market opportunities. This natural human optimism and cynicism based on expectation, is an important aspect of modern macroeconomics - which can cause inflation in itself. Changes in business confidence are made worse by 24-hour media coverage and instant access to financial market data. The media relies on this type of data and tends to feed on headline bad news such as company announcements regarding job cuts, contracts lost or company administration's. Where as in times of growth, the media rarely questions the level of gearing or business debt within an individual enterprise.
The Solutions to Influence Inflation or Deflation - the main macro economic solutions to inflation or deflation, focus on changing levels of demand and supply within the economy. They are as follows:-
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Change the Level of Money Supply - by limiting or increasing the quantity of money available to chase within the economy, inflation can be controlled. This can be achieved by a mixture of measures. Firstly, The Bank of England has the power to either restrict or alternatively 'print' money through the 'quantitative easing' process, by buying assets in exchange for money. This will normally consist of buying securities (like government debt, mortgage-backed securities or even equities) from banks. Secondly, by either extending or limiting the amount of liquid cash and balances reserves banks are able to access from the Bank of England, onward lending to small businesses or individuals is changed. Thirdly, by restricting the level of banking credit controls through regulation, the central bank can influence how much money is available to lend and borrow within the economy. Lastly, by changing the percentage of retail banks total liabilities required 'reserves' with the bank of England, money supply can be restricted or expanded.
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Fiscal Policy - governments change direct and indirect business taxation and personal taxation every year at budget time. They also confirm changes to the level of expenditure on public services such as schools, hospitals and defence. These changes represent the government's fiscal policy and a major factor in influencing the levels of inflation or deflation within an economy. For instance, large income-tax increases may have the impact of reducing individuals personal disposable income. This may lead to a reduction in consumer spending on the high street and dampen inflationary pressure. Conversely, huge tax cuts may encourage more people to spend more on houses, cars and holidays. This boosts the economy and keep inflationary growth going. UK inflation is highly sensitive to consumer spending and the housing market and so many small businesses provide business services (as opposed to manufacture or produce products).
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Monetary Policy - as mentioned previously, by controlling base interest rates, the cost of debt becomes cheaper or more expensive. This as a major impact on firms ability to invest and individual's ability to borrow and consume. Most small firms rely on overdraft facilities or a bank loan in order to manage their cash flow. When the cost of money increases, firms spend less, employ less people and pay less corporation tax (as company profits tend to fall). The cost of government borrowing also increases, reducing the government's ability to increase public expenditure without raising tax.
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Supply or Capacity Based Policies - by improving the efficiency of markets the country has the potential to produce more, in order to cope with an increased level of demand. This can be achieved by providing better training and educational resources, taxes cuts to encourage entrepreneurial innovation, financial deregulation and reductions in union power to reduce wage bills.