Practise distinguishing inflation, deflation and disinflation, calculating CPI and real values and evaluating causes and consequences of changing the general price level.
The graph shows the rate of inflation for seven countries for 2015 and 2016.
What can be concluded from this graph?
Prices in Costa Rica rose in 2015 but remained constant in 2016.
Prices in Ecuador and Mauritius were lower in 2016 than in 2015.
Prices in India and Malaysia remained constant in 2016 and 2015.
Prices in Thailand and Japan were lower in 2016 than in 2015.
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
Describe what has happened to consumer prices in the Eurozone between March 2021 and February 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.
Turkey's unconventional way of managing its economy
The relationship between interest rates and the general price level is one that is central to macroeconomic theory; namely that an increase in the rate of interest produces a reduction in the rate of inflation in an economy. Most economists agree on this relationship. Not so, according to President Erdoğan of Turkey, who has defied conventional economic theory in tackling his country's fundamental economic challenges.
Two economic challenges stand out. There is spiralling inflation and a collapse in the external value of Turkey's currency (the lira) in the foreign exchange market, as shown in Fig. 1.1.
Turkish lira per US\$
Fig. 1.1 Inflation and the exchange rate of Turkey, January 2020 to February 2022
In January 2022, the year-on-year rise in consumer prices was 48.7 %, against a 36.1 % year-on-year increase for December 2021. Much higher food prices and transport and energy costs accounted for most of the increase. Despite this rise, the country's Monetary Policy Committee (MPC) held the short-term interest rate at 14 %. This was the rate set in September 2021 when the MPC cut the rate substantially from 19\%. In short, the President had used his influence over the MPC to reduce interest rates in an attempt to reduce the increasing rate of inflation.
The President's unconventional approach has had a dramatic effect on the external value of the lira. The rapid depreciation in the value of the lira from September 2021 has had serious repercussions for Turkey's economy as Mr Erdoğan has sought to prioritise exports over currency stability. Consumer and producer confidence are low; many who can, have converted their lira deposits into US dollars or euros, fearing a collapse of the banking system.
Despite these problems, the President remains adamant that his economics is right for Turkey. Moreover, he is convinced that when exports increase and international tourists return after the COVID-19 pandemic, employment will increase and the current account deficit on the balance of payments will be reduced. If true, this unconventional approach to Turkey's economic problems will be proved to be a success.
Use the information provided to calculate the real interest rate for Turkey in January 2022.