LRP*

SRP*

AD1 inflationary gap

Y

Y* SRY*

F I G U R E 8 . 8 I N F L A T I O N A R Y G A P : C L A S S I C A L A P P R O A C H

According to a classical approach (as shown in Figure 8.8) no intervention by the government would be required, prices and wages would not be sticky in the short run and the economy would adjust from its initial short-run position by the price level rising from SRP to LRP and output would decline back from SRY to Y .

8.3.2TRENDS IN INTERNATIONAL PRICE LEVELS

From Figure 8.6 we see that changes in either short-run aggregate demand (a rise) or short-run aggregate supply (a fall) give rise to inflation with different consequences for national output. A one-off jump in prices caused by rising aggregate demand or falling aggregate supply is not considered particularly damaging to an economy but policy-makers and analysts consider that attempts should be made to curtail persistent inflation, whatever its cause, if at all possible. A relevant question, though, is why we observe inflation in economies at all. In looking at the trend in price levels in a historical context we find that between 1661 and 1930, average UK prices did not show any continual upward trend and in fact it was not until the twentieth century that prices increased sharply (based on price data that were compiled by B.R. Mitchell, 1988; figures for the US display a similar pattern).

More recent inflation data are presented in Figure 8.9, which shows trends in the consumer price index (CPI) of some selected countries over the last three decades. We see that inflation has been observed for most countries shown for the vast majority of the last 30 years, being highest over the initial decade, and highest on average for the United Kingdom and Ireland. Deflation was observed in Germany for 1986, Sweden in 1998 but more persistently for the final four years of the sample period in Japan.

goods they do not follow exactly the same trends over time; however, over the long run they tend to move together.

W H Y I N F L A T I O N ?

Why do the prices of goods and services generally tend to rise over time? Several possible reasons have been put forward. It could be because:

•Firms increase their prices trying to make higher profits and consumers cannot react by buying cheaper substitutes.

•Firms facing increased costs pass them on to consumers.

•Improvements in the quality of products mean goods cost more due to either better inputs or technology and consumers are happy to pay the increased price.

•Consumers’ nominal incomes are rising and, following the quantity theory (and assuming money supply and velocity are constant), if income rises then so too will prices to keep real income unchanged.

Each potential explanation sounds plausible and provides a contribution to our understanding of why the average level of prices is upward over time. Unfortunately, no single or indeed simple explanation for inflation exists but as Figure 8.9 indicates it is a very pronounced international phenomenon. The role of oil prices in international inflation is considered in the text box.

O I L P R I C E S A N D I N F L A T I O N

Across most developed countries inflation increased in the period following the first oil price shock of 1973 (see www.wtrg.com/prices.htm for trends in oil prices). The Organization of Petroleum Exporting Countries (OPEC) was formed in 1960 with five founding members: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela, and by the end of 1971 six new members – Qatar, Indonesia, Libya, United Arab Emirates, Algeria and Nigeria – had joined too. These countries operated a cartel (as explained in Chapter 6). The aim of such collusion is to increase profit by reducing competition. These nations had experienced a decline in the real value of their product since foundation of the OPEC. Throughout the Post-World War Two period, exporting countries found increasing demand for their crude oil and a 40% decline in the purchasing power of a barrel of crude.

In 1972 the price of crude oil was about $3.00 per barrel. By the end of 1974 it had quadrupled to $12.00. The Yom Kippur War started with an attack on Israel by Syria and Egypt on 5 October 1973. The USA, among other western countries, showed strong support for Israel. As a result Arab oil-exporting nations imposed an embargo on the nations supporting Israel. Arab nations reduced production by 5 million barrels per day (MBPD). About 1 MBPD was made up by increased production in other countries. The net loss of 4 MBPD extended through to March 1974 and represented 7% of the free-world production. The extreme sensitivity of prices to supply shortages became all too apparent and is known as the oil-price shock. Since oil is a significant input into so much of the production process – machinery, equipment, transportation etc. – the oil-price shock had substantial inflationary implications as seen from Figure 8.9. From 1974 to 1978 nominal crude oil prices increased at a moderate pace from $12 per barrel to $14 per barrel, but in real terms, i.e. when adjusted for inflation, the prices were constant over this period of time.

A further sharp increase in oil prices in 1979 occurred on the back of the Iranian Revolution and became known as the second oil-price shock. The decline in production that occurred in 1985/86 was triggered by Saudi Arabia’s rebellion against its role as the world’s swing producer. It implemented a new and ultimately successful pricing strategy to regain its market share, which became the third oil-price shock. Although prices jumped up again in 1990, in response to Iraq’s invasion of Kuwait, this was not sustained and, therefore, is not generally classified as a fourth shock.

It is worth remembering that as long as people are compensated in their earnings for rises in the average price level, people are no worse off in real terms as a result of inflation. This is an important point because when it comes to wages, in particular, we have seen already that under the Keynesian view of economic activity, wages tend to be ‘sticky’ or fixed in the short run, and that the short run can persist for some time.

Not only do wages not tend to fall in times of unemployment, but neither do wages tend to adjust upwards unless workers can put credible pressure on their employers to increase wages. Since wage-bargaining does not take place continually but occurs periodically there tend to be discrete jumps in wages rather than a steady increase. Where trades unions are involved in wage-bargaining, they argue for the best outcome possible for their members and attempt to secure the highest