Practise separating demand-pull from cost-push inflation, drawing the appropriate AD or AS shift and evaluating wages, commodities, exchange rates, spending and policy evidence.
Answer all parts of this question.
Dilemma for the European Central Bank (ECB)
The Eurozone consists of 19 European Union (EU) states that have agreed to use a common currency (the euro) and monetary policy, both of which are governed by the ECB. The ECB sets interest rates for all 19 members of the Eurozone and since July 2021 has aimed to maintain the rate of inflation at in the medium term. Interest rates have been held at since March 2016.
Fig 1.1: Eurozone Consumer Prices Index (CPI) March 2021 - February 2022
In March 2022, the annual rate of inflation hit a record high for the Eurozone of and is forecast to continue to rise throughout 2022. Additionally, according to the ECB vice president, annual economic growth is expected to fall from at the end of 2021 to around at the end of 2022. Most of the impact of these changes is expected to fall on consumers. Much higher energy costs and rising food prices tend to have a more severe effect on poorer households and those on fixed incomes.
The main causes of the rapid increase in the inflation rate are supply-side factors. The rise in energy prices result from a combination of the Covid-19 pandemic and the conflict between Russia and Ukraine which have reduced supplies of oil and gas. Additionally, the Eurozone labour market is increasingly suffering from a shortage of supply as unemployment has fallen to a record low of in February 2022 with further falls predicted. Because the rise in the rate of inflation is almost exclusively supply-side driven, the ECB fears that this will lead to further falls in economic growth leading to a period of 'stagflation', where an economy experiences high inflation and low economic growth at the same time.
Fig 1.2: Eurozone \% unemployment rate March 2021 - February 2022
All this leaves the ECB with a dilemma. Should it:
- increase interest rates substantially now to control the increasing rate of inflation and risk weakening economic growth even further, or
- increase them slightly in the hope that supply pressure will ease soon (this runs the risk of making high inflation more permanent if the pressure does not ease), or
- leave interest rates unchanged?
Sources, adapted from: reuters.com 31 March 2022 and reporting by Balazs Koranyi 1 April 2022
With the help of an aggregate demand and aggregate supply diagram, identify the main type of inflation in the Eurozone.
Consider the extent to which the shortage of supply of labour in the Eurozone may have contributed towards the increasing rate of inflation.