Inflation, Employment and the Balance of Payments

Inflation

Inflation is a sustained rise in the general price level, and therefore a fall in the purchasing power of money.

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• Deflation: a sustained fall in the price level.
• Disinflation: inflation that is still positive but falling. Prices are rising more slowly, not falling.

Measurement: the CPI. A representative "basket" of around 700 goods and services is priced monthly. Each item is weighted by its share in average household spending, so a change in petrol prices affects the index far more than a change in the price of stamps. The UK inflation target is 2% CPI.

Limitations of the CPI:

• It is an average; different households face different inflation rates depending on what they buy.
• It adjusts for quality improvements imperfectly, a phone that costs the same but does far more has effectively fallen in price.
• The basket is updated only annually, so it lags changes in spending patterns.
• It excludes housing costs (unlike CPIH and the older RPI), which matters greatly for younger households.
• Sampling error, and the exclusion of the informal economy.

Causes of inflation:

• Demand-pull: AD rises faster than the economy's capacity to supply, typically with a positive output gap. Shown as AD shifting right along a steep section of AS.
• Cost-push: rising costs of production (wages, imported raw materials, energy, indirect taxes, a depreciating exchange rate) shift SRAS left, raising prices and lowering output.
• Monetary: in the quantity theory, MV = PQ; if the money supply grows faster than real output, the price level rises.
• Expectations: if workers and firms expect inflation, they build it into wage claims and prices, and it becomes self-sustaining. This wage–price spiral is why central banks defend their credibility so fiercely.

The distinction is decisive for policy: demand-pull inflation is treated by restraining demand, but the same treatment applied to cost-push inflation deepens the fall in output. Cost-push inflation combined with falling output is stagflation, and it forces a genuine policy trade-off.

Costs of inflation: eroded purchasing power (especially for those on fixed incomes); loss of international competitiveness; menu costs and shoe-leather costs; uncertainty that deters investment; arbitrary redistribution from savers and lenders to borrowers; and fiscal drag as nominal incomes push taxpayers into higher bands.

Costs of deflation are frequently underrated: consumers delay purchases expecting lower prices, so demand falls further; the real value of debt rises, squeezing borrowers; and nominal interest rates cannot fall below roughly zero, so monetary policy loses traction. A deflationary spiral is harder to escape than moderate inflation, which is why the target is 2% rather than 0%.

Employment and unemployment

Measurement:

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• The Labour Force Survey (LFS): an internationally comparable survey counting those without a job who are available to work and have actively sought work in the past four weeks. This is the preferred measure.
• The claimant count: those claiming unemployment-related benefits. Cheap and timely, but it is affected by every change to benefit rules and excludes those who are unemployed but ineligible.

Both understate true labour market slack, because they miss discouraged workers who have stopped looking, and underemployment, part-time workers who want full-time hours.

Types of unemployment:

The natural rate of unemployment is the rate that persists when the labour market is in equilibrium, frictional plus structural. It cannot be reduced by raising AD; only supply-side measures lower it.

Costs of unemployment: lost output (the economy operates inside its PPF); lost tax revenue and higher benefit spending, so a wider deficit; hysteresis, where long-term unemployment erodes skills and permanently lowers potential output; and the personal and social costs of poverty, ill health and crime.

The current account of the balance of payments

The current account records trade in goods, trade in services, primary income, profits, interest, dividends, wages from abroad, and secondary income (transfers, aid, remittances).

Causes of a deficit: loss of international competitiveness through higher relative inflation or poor productivity; a strong exchange rate; strong domestic growth pulling in imports; a narrow export base; and structural decline in exporting industries.

Consequences: a leakage from the circular flow, so lower AD and employment; the need to finance the gap by borrowing or selling assets abroad; downward pressure on the exchange rate under a floating system, which is partly self-correcting; and, under a fixed system, falling reserves.

But a deficit is not automatically a problem. A deficit financed by inward investment, or caused by importing capital goods that raise future capacity, is very different from one funding consumption. Making that distinction is a reliable evaluation point.

Working the numbers

Three calculations AQA sets from a data extract, and each has a trap in it.

Inflation from a price index. CPI rises from 108.0 to 111.2.

Inflation = (111.2 − 108.0) ÷ 108.0 × 100 = 3.0%

Note what the index level does not tell you. A CPI of 111.2 means prices are 11.2% above the base year, not that inflation is 11.2%. Reading the level as the rate is the classic error.

Building a weighted index, since the CPI is a weighted basket rather than an average of price changes:

Weighted index = 10,660 ÷ 100 = 106.6, so inflation since the base year is 6.6%.

Housing rose most and carries the largest weight, so it dominates. A large rise in a small category moves the index far less than a small rise in a large one, which is the whole point of weighting.

The unemployment rate. An economy has 31.5m employed and 1.4m unemployed.

Labour force = 31.5 + 1.4 = 32.9m
Unemployment rate = 1.4 ÷ 32.9 × 100 = 4.3%

The denominator is the labour force, not the working-age population, the single most common calculation error in this topic. Anyone economically inactive sits outside it entirely, which is why the measured rate can fall in a downturn as discouraged workers stop searching.

Then the real value. If nominal wages rose 2.5% while inflation was 3.0%:

Real wage change ≈ 2.5% − 3.0% = −0.5%

Purchasing power fell despite a pay rise. Stating that, rather than the nominal figure, is what the question is testing.

Worked example

An economy experiences a sharp rise in world energy prices.

1. Imported energy is an input to almost all production
2. firms' costs rise
3. SRAS shifts left
4. the price level rises and real output falls
5. cost-push inflation with rising unemployment: stagflation.

Simultaneously, the higher cost of imported energy worsens the current account, since the same volume of imports now costs more.

The policy dilemma, which is the substance of the question:

• Raising interest rates to control inflation reduces AD further, deepening the fall in output and raising unemployment. It addresses a cost-push problem with a demand-side tool.
• Loosening policy to protect output risks entrenching inflation in expectations, triggering a wage–price spiral that is far more costly to unwind later.
• Supply-side measures: energy efficiency, diversifying energy sources, investment in domestic generation, address the actual cause, but operate over years, not months.

Evaluation.

• Much depends on whether the shock is temporary or persistent. A one-off price spike that does not feed into expectations may be best accommodated, since the inflation will pass; a persistent one must be resisted to protect credibility.
• Second-round effects are the real risk: if workers secure compensating wage rises, the cost shock becomes generalised inflation.
• The distributional effect is severe and regressive, energy is a necessity with inelastic demand, so it takes a far larger share of low incomes.
• The current account may partly self-correct if the currency depreciates, improving export competitiveness, though that raises import prices further, worsening the inflation.

Judgement: cost-push inflation offers no costless option. The defensible approach is to hold monetary policy steady while the shock passes, provided inflation expectations remain anchored, and to use targeted fiscal support for the households worst affected rather than general demand stimulus.

Common exam mistakes

• Confusing deflation (falling prices) with disinflation (slowing inflation).
• Treating all inflation as demand-pull, the diagram and the policy differ entirely for cost-push.
• Saying inflation is always harmful; moderate, stable inflation is preferred to deflation.
• Confusing cyclical with structural unemployment. The policy response is completely different.
• Saying the natural rate can be lowered by raising AD, only supply-side policy lowers it.
• Treating a current account deficit as automatically bad without asking what is causing it.

Exam technique

Use AD/AS diagrams and make the direction do the work: demand-pull shifts AD right (price level and output both rise); cost-push shifts SRAS left (price level rises, output falls). The examiner can see immediately which you mean.

Name the type of unemployment before recommending a policy, recommending demand stimulus for structural unemployment is the classic error.

For evaluation, reach for expectations (whether inflation becomes entrenched), hysteresis (why long-term unemployment is uniquely costly), and the cause of any current account deficit.

Quick revision

• Inflation = sustained rise in the price level. Deflation = falling prices. Disinflation = slowing inflation.
• CPI: weighted basket, 2% UK target; excludes housing costs, adjusts poorly for quality.
• Causes: demand-pull (AD right), cost-push (SRAS left), monetary, expectations.
• Deflation is dangerous: delayed spending, rising real debt, ineffective monetary policy.
• Unemployment measured by the LFS (preferred) and the claimant count; both miss discouraged and underemployed workers.
• Types: frictional, structural, cyclical, seasonal, real-wage.
• The natural rate = frictional + structural; only supply-side policy lowers it.
• Hysteresis: long-term unemployment permanently lowers potential output.
• Current account: goods, services, primary income, secondary income. A deficit's significance depends on what is causing it.

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