Wednesday, May 9, 2007

Essay: Reasons for Low Inflation in the UK

Q. Discuss Reasons for Low Inflation in the UK? (30)

Despite recent increases in inflation, by historical standards, inflation in the UK is very low (3% as opposed to 10% in 1990). Since independence of the B of England, in 1997, inflation has remained close to the governments target of 2% Many feel the MPC has played a pivotal role in keeping inflation low. However, there are also other reasons to consider such as; globalisation, commodity prices and supply side reforms.

Factors explaining Low Inflation in UK

1. Independent Bank of England - MPC

The MPC has sought to maintain low inflation and sustainable economic growth. It has managed interest rates to avoid inflationary growth. If the economy was expanding too quickly interest rates were increased to prevent future inflation. This is known as pre-emptive monetary policy, interest rates increased BEFORE inflation becomes a problem. As a consequence of this policy, growth has been close to the long run trend rate, and this has been a significant factor in maintaining low inflation.
(AD increasing at same rate as AS)

2. Lower Inflation Expectations

Related to the independence of the MPC, is the fall in inflation expectations. Because people expect low inflation it is easier to create low inflation. For example, workers do not bargain for high wage increases. Firms don't expect to be able to pass price increases on. It is a virtuous circle.

3. International Price trends.

It is not just in the UK that inflation has fallen. Other OECD countries have seen low inflation. For example, the process of globalisation has seen falling prices of manufactured goods, often produced in China. Several commodity prices have also been increasing at low rates, although recently they have started to increased.

4. New Technology.

New technology has helped to reduce the costs of firms. Therefore, the AS curve will shift to the right. For example, the internet and improvements in microchip computers have helped to reduce costs for firms.

5. Supply side reforms in the UK.

Supply side policies implemented since the 1980s have helped to reduce cost push inflation. For example, privatisation has seen public companies become more efficient, leading to lower prices. Privatisation was often accompanied by deregulation, which seeks to increase competition and therefore reduce prices. It is hard to quantify the contribution of supply side reforms to reducing inflation, but, they have had a benefit.

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