Inflation & Deflation

Deflation is...

- A general fall in prices in the economy. - Deflation means that, on average, the products are cheaper to buy than before. - However, the term "deflation" is also used to describe a recession in the economy, when the inflation rate is falling but inflation is still positive.

Inflation is...

- A general rise in prices in the economy - A 5% inflation rate over the past 12 months, for example, means that the average increase in prices across the economy during the past year was 5%

Deflation can also lead to problems for businesses...

- A stagnant economy - Reducing costs

Deflation tends to be associated with...

- An economy which is not growing in size, which might even be shrinking. - This is because falls in price are often associated with falling levels of demand. Consumers are reluctant to spend money. Businesses don't want to increase their investment because their output is stagnant. In a stagnant economy, problems could be made worse by rising unemployment. This also tends to reduce the willingness of consumers to spend and borrow. Many businesses could face falling demand for their products or services if they are selling into markets which are in decline because of changes in spending patterns.

Wage -price spirals...

- Cost-plus inflation and demand-pull inflation tend to feed off one another.This is known as a wage-price spiral. - It often starts through a supply-side shock, such as a sudden increase in import prices. Businesses put up their prices to remain profitable. Higher prices lead to workers demanding large pay rises. If they don't get wage rises which are at least as large as the increase in inflation, the standard of living will fall. This is because their wages won't be able to buy as much as before at the new high prices. Large wage increases lead to an increase in aggregate demand as workers spend their pay increases. However, businesses are forced to put up their prices again because their wage costs have increased. This leads to more wage demands and so on.

In terms of SLSL...

- Deflation is unlikely to occur as deflation last occured during the recession and the economy is now slowly recovering. Deflation doesn't occur very often in the UK, and mostly occured between 1920 and 1930.

There are two main types of inflation...

- Demand-pull inflation - Cost-push inflation

Stable inflation is maintained through the role of expectations...

- If all economic agents in the economy expect inflation to be the same as before, then they will act in a way that ensures that it is achieved. For example, if everyone expects inflation to be 2%, then workers will negotiate pay rises of 2% plus a little more to give them higher spending power than before. - Similarly, businesses will base their price rises on expected inflation. If expected inflation is 2%, business will tend to raise their prices by a few per cent. If expected inflation is 20%, they will put up their prices by around 20%. The whole economic system can be stable if every economic agent acts on common expectations. - But it can be unstable if different economic agents have different economic expectations. For example, a wage spiral may begin if workers suddenly demand and obtain pay increases of 10% when expected inflation has been 5%.

Strategy and inflation...

- If inflation is low, businesses are unlikely to need to have strategies to cope with changing prices. It is only when inflation rates rise considerably that businesses may need to adapt their strategies

SLSL might strategically respond to an increase in the rate of inflation by charging higher commission rates...

- If the rate of inflation increased in the future by a significant amount SLSL would face increases in its costs either from overheads or higher wages. In response to this the firm could increase the commission rates it charges. It currently charges on average around 1% based on the negotiating skills of staff, which could be raised to 1.5% - 2% in order to match inflation and prevent SLSL from losing out on revenue in the long-term. - However, SLSL would probably have to spend time researching the behaviour of its competitors, as increasing commissions rates may discourage buyers and vendors if the commission rates charged by competitors stayed the same. This would cause SLSL to lose sales and market share.

High and particularly fluctuating inflation is likely to be damaging to a business for a number of reasons...

- Increased costs - Uncertainty - Borrowing and lending - Consumer reactions

Borrowing and lending becomes and opportunity and a problem for businesses...

- Inflation initially benefits borrowers and harms lenders. - On the one hand, the real value of debts incurred in the past can become quickly eroded by inflation. If inflation is 100% per annum, the real value of money borrowed a year ago is halved in one year. - But in an inflationary environment, interest rates rise to match inflation. If inflation is 100%, interest rates might be 110%. Therefore causing debts to only be eroded for a short amount of time. - In terms of SLSL, they owe £50,000 to Andrew Boddie which currently has an annual interest rate which is 3% above the UK base rate. If inflation was 10% in 2012, the UK base rate may increase causing an annual interest rate of 13%, for example.

Levels of inflation and deflation...

- Inflation isn't necessarily a problem. If prices are rising by a few per cent each year, and the inflation rate is fairly constant, inflation is likely to have little impact on businesses. - The situation is likely to be different if inflation is high. At 5% and over, businesses have to be managed to cope with inflation. When inflation gets over 20% per annum, there are serious consequences for businesses. This is particularly true if inflation is fluctuating. (e.g. 5% to 25% to 150% to 10% within a four year period.) - Equally, even quite low levels of deflation can have a significant impact on business. So there is considerable difference between 2% inflation per year, which has little or no effect on business, and 2% deflation.

Management is likely to have to spend more time dealing with workers' pay claims...

- Instead of being able to sign a two or three year deal, annual pay negotiations are likely to be the norm. - There is also a larger risk of strikes because workers and managers will probably have different views of future inflation rates. Workers will be worried that any deal they make will leave them worse off after inflation. - In terms of SLSL, there is unlikely to be any strikes as the staff currently receive a bonus based on the company profits which would fall if strikes were to take place. There is also discussion about a branch based bonus linked to sales, which is likely to discourage strike action further.

Consumers react to inflation as well as businesses...

- Prolonged inflation tends to lead to more saving. The value of savings tends to fall as inflation erodes their real value. So people react by saving more to make up savings to their previous real value. Increased saving means less spending. They also become less willing to borrow money, not knowing what will happen in the future. - In terms of SLSL, this means that people will be less confident about spending and therefore less likely to purchase a house. House prices would also rise, so people would be less likely to afford mortgage payments if their savings were eroded by inflation.

SLSL might strategically respond to an increase in the rate of inflation by reducing its costs...

- The Roleys idea of web based marketing may be a better idea than pushing up commission rates as the costs of physical premises are likely to increase greatly with a high rate of inflation. By only operating online, SLSL will benefit from a significant reduction in costs, allowing the business to survive without having to charge more to customers. This may even give SLSL a USP, if competitors raise their commission rates to cope with inflation. - However, this is likely to lead to high redundancy costs as SLSL currently employs 19 members of staff. Some of the staff at Oakford and Upham may have been employed for a long time considering SLSL was founded in the mid 1980s. SLSL also hasn't conducted much research into this venture, and so more will need to be conducted to establish whether this venture is worthwhile.

How does cost-push inflation affect SLSL...

- There is no mention in the case study of anything that could cause cost-push inflation, especially the main causes listed. - If cost-push inflation were to occur then this would cause prices of all goods in the economy to rise. This may mean that people have less disposable income (unless wages rose) causing them to feel less confident about purchasing a house. - However, if this type of inflation were to occur it may not be all bad for SLSL, as an increase in housing prices would cause SLSL to receive higher commissions on each property sold. Although, their costs may rise at the same time.

Raising prices costs money...

- This is because customers have to be made aware of these new prices. In terms of SLSL this probably wouldn't come at much of a cost as they may only need to update their website and change some signs in the window. - Their advert in Oakford Oracle is updated weekly, so they could probably afford to wait a week to change it due to the small amount of activity in the housing market. - The sales staff would need to be made aware of any changes, which could probably be incorporated into the "weekly email Alistair sends to all staff offering an economic briefing." - These are called menu costs because, for a restaurant, increasing prices means that it has to reprint its menus.

Demand-pull inflation...

- This is caused by too much demand in the economy as a whole. Typically the economy is booming and output (aggregate supply) is not keeping up with the spending of customers (aggregate demand.) - Shortages may develop in some parts of the economy because businesses are working at maximum capacity. In these circumstances, businesses are under little pressure to give discounts to buyers. Many might also put up their prices without losing customers. - In terms of SLSL, the economy is currently slowly recovering from a recession. So, this kind of inflation is unlikely to affect house prices and the purchase of houses at this point in time.

Deflation means the businesses are being forced to cut their prices...

- When deflation initially occurs, businesses may choose to pay for the price cuts by simply cutting their profits or accepting a loss for the year. But if inflation is prolonged, businesses have to cut their costs to survive. - Cost cutting year on year is very difficult. It may be possible to achieve lower costs through more efficient production methods. An alternative is to cut the wages of workers. However, this is likely to lead to demotivation. It is perhaps more difficult to manage a business that continually has to cut its prices than it is to manage one where prices can be slowly pushed upwards.

Uncertainty...

- With high and fluctuating inflation, businesses don't know what prices will be in three or six months time, let along in one or five years. But decisions have to be made now which will affect the business in the long term. - For example, businesses need to invest in order to survive. In terms of SLSL, they have many ideas for expansion such as a move to Market Harworth or a move into lettings management. These are likely to require a large investment. However, this investment may be much higher six months or a year from now, so SLSL should invest will inflation is (assume to be) low. - Another problem with uncertainty is linked to entering long-term contracts. In terms of SLSL, a typical sale of house (as shown in figure 1) takes around 4-5 months. During this time inflation could have risen significantly causing the house to be worth much more, but the valuation took place in the first three days. So, SLSL is forced to sell the house at the original valuation.

Shoe leather costs...

- With suppliers prices rising all the time, but at different rates, time must be spent researching the market for the best deals. In terms of SLSL, the time and money spent researching these deals probably wouldn't be worthwhile as SLSL only had a stock value of £5,000 at the end of 2011, thus meaning they could probably remain profitable with the same suppliers. - Equally, more time has to be spent tracking the prices of competitors to decide when and by how much to increase your own prices. In terms of SLSL, the actual valuation of the house isn't a factor as estate agents don't take title and therefore don't determine prices. However, the rate of commission may rise with inflation amongst local estate agents, so it may be worthwhile for SLSL to research these changes in order to remain competitive. - These costs are called shoe leather costs because before the age of the telephone and the Internet, businesses would have to sent their employees around on foot to gather this information.

Cost-push inflation...

This occurs when costs of production rise without there being any rise in aggregate demand in the economy. Costs may rise for a number of reasons: - In the past cost-push inflation has occured mainly due to sharp rises in the cost of imported goods, such as oil. For example in the 70s the cost of oil quadrupled from around $5 a barrel to $20. The led to large price increases throughout the economy. Inflation in 1975 reached 24.1% - Rises in wages cause cost-plus inflation. The power of trade unions has risen and fell over the years and this affects how much wages increase every year. - If the government increases taxes on goods and services, inflation will rise. For example in 1979, VAT was increased from 8% to 15%. This caused inflation to go up 5% that year. - If business decide to earn more profit, this will cause price increases, and therefore higher inflation.