Urrent recessionary situation in the UK economy Essay

Urrent recessionary situation in the UK economy - Essay Example The most common among these are the Consumer price index and the retail price index. The simplest way to understand the mechanism behind changes to inflation is through Aggregate Demand and Aggregate Supply dynamics. Given the economy is in macroeconomic equilibrium, if there is a positive shock to demand, i.e., aggregate demand shifts up, the price level rises. This is known as demand pull inflation. This type of inflation is observed particularly during periods of economic expansion. This is shown in figure 1 below. Figure 1: Demand-pull inflation In the diagram, SRAD represents the short run dynamics of demand; it shows how changes to aggregate demand are related to changes in the price level or inflation. Similarly, SRAS represents the short run dynamics of aggregate supply. Because of an expansionary shock to short run aggregate demand (SRAD), inflation increases from Is to Id. Again, even if short run demand remains unchanged, inflation can increase due to supply side shocks. In the diagram, SRAD represents the short run dynamics of demand; it shows how changes to aggregate demand are related to changes in the price level or inflation. Similarly, SRAS represents the short run dynamics of aggregate supply. Because of an expansionary shock to short run aggregate demand (SRAD), inflation increases from Is to Id. Again, even if short run demand remains unchanged, inflation can increase due to supply side shocks. For instance if there are bottlenecks in the supply chain which leads to contraction of supply, the short run aggregate supply curve shifts up to the left. This leads to an increase in inflation as well. This is known as cost push inflation since this happens due to sudden increases in production costs. Well known examples of such inflation generating cost rises over the years have been oil price shocks, labor market strikes etc. This mechanism is illustrated in figure 2 below. In Figure 2: Cost push inflation In the graph above, the SRAS curve is hit by a temporary shock resulting from increases in costs. The resulting movement to the left and up leads to a rise in the inflation rate from Is to Ir. It should b e noted that all factors that influence demand and supply mechanics can therefore influence inflation rates. Particular note should be taken of inflation expectations. If inflation is expected to rise in future, people start buying immediately and such behavior leads to the prices being pushed up. This is a simple instance of how inflation expectations constitute self fulfilling prophecies. Being armed with an understanding of the basic mechanics of inflation, we now turn to the actual observed situation in the UK economy. The UK economy is undergoing a substantially adverse situation. Although the Bank of England sets 2% as inflation target, the annual percentage change in Consumer Prince Index reached a 2 year high of 5.2% in January 2011. Although it has come down since then to around 4.2% in recent months, it still is considerably higher compared to the declared target of the Bank of England (BBC, 2011). What makes this situation precarious is that this inflation has occurred at a time when the economy was already reeling from a strong recessionary pressure. The global economic crisis and the ensuing recessionary pressures had seem the inflation rate hit a low of almost 1% in 2009. The recession has led to significant stress on the economy and caused losses of employment. In all other advanced economies, the recession has been associated with a disinflation, if not a deflation. In the UK economy however the inflation rate has climbed up substantially to hit the aforementioned highs (Dwyer et al., 2010). There are alternative viewpoints to explain this phenomenon, and we turn to these various explanations in the rest of this article. Figure 3: Inflation in UK, ONS data Figure 1 traces the quarterly movements of