ANALYSIS OF THE RECENT PATH OF UK INFLATION1
| Author | Penelope A. Rowlatt |
| Published date | 01 November 1988 |
| DOI | http://doi.org/10.1111/j.1468-0084.1988.mp50004001.x |
| Date | 01 November 1988 |
OXFORD BULLETIN
of
ECONOMICS and STATISTICS
Volume 50 November 1988 No.4
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 50,4(1988)
0305-9049 $3.00
ANALYSIS OF THE RECENT PATH
OF UK INFLATION'
Penelope A. Rowiatt
INTRODUCTION
It is a familiar fact that prices of all types tend to move together: wages follow
prices of goods and services, prices follow wages, the currency depreciates
more when domestic inflation is high than when it is low compared to that
abroad. Inflation seems to have a dynamic of its own. However, there are
other factors which tend to increase or reduce domestic inflation rather than
just allowing it to continue at its own rate. Examples include market dis-
equilibria, the rate of inflation in other countries, deviations of growth rates
from trend or expected levels, changes in the rates of taxation or in the real
levels of administered prices and so on. A full understanding of the inflation
process requires the separation of the internal dynamics of the domestic infla-
tion spiral from these other factors that can be treated as being exogenous to
it. For this a model of the inflation process is needed.
The analysis in this paper relates inflation to the proximate influences on
price rises - those that are included in structural equations describing price-
setting in the relevant markets. For the purpose of this work these are treated
as exogenous: the analysis does not look behind these influences to explain
their paths in terms of the factors that determine them, such as policy instru-
ments, nor does it take account of any feed-backs on to them from the infla-
tion spiral.
This work has benefited from the advice of Huw Evans, Chris Melliss and, most particu-
larly, John Odling-Smee. It also incorporates comments made by the members of the Treasury
Academic Panel. Opinions are my own, not necessarily the same as those of HM Treasury;
errors, of course, are mine.
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There are three markets that are involved in the generation of domestic
price inflation. The domestic goods and services market sets the mark-up on
the cost of the inputs; the labour market sets the price of the labour inputs;
the foreign exchange market affects the domestic currency cost of imported
material inputs and foreign competitors' prices for given world prices. The
world market for primary commodities, which sets the price of materials and
fuel in world currencies, and foreign finished goods and labour markets will
also influence the prices of imported manufactured goods and services and so
have an effect on domestic price-setting, but these are treated as being
exogenous to domestic price-setting in this paper.
Section I of the paper describes the equations used for price-setting in each
of these markets; a more precise listing of them is given in the Appendix.
These equations are derived from micro-theoretic principles and have been
fitted to recent UK data. They are closely related to equations that are, or
have been, incorporated into the Treasury model. In Section II these
equations are combined to give a reduced form equation for price inflation in
the UK and this is used to investigate which factors seem to have been most
important in determining inflation in the UK over the past 15 years.
I. THE MODEL
The credibility of an analysis of the sort given in the second section of this
paper rests on the soundness and general acceptability of the model on which
it is based. This section describes the rationale for the equations used in
Section II to analyse the recent path of inflation in the UK, lists their general
forms and notes their most important properties. A more precise listing of
them is given in the Appendix along with an explanation of some of the
details of their structure.
The Equation for the Producer Output Price Index
The equation for producer output price inflation is derived from the assump-
tion that firms take decisions about the price they charge at the same time as
deciding their output and inputs, given the prices of inputs, with the object of
maximizing some measure of their profits, and that the demand for their out-
put is sensitive to the price charged. The result is a price that can be viewed as
a mark-up on costs with the mark-up depending on competitors' prices and
on the level of demand. The equation used in the model assumes a dynamic
adjustment process with a feed-back from any disequilibrium in the price
level existing in the previous period. Its general structure is shown in equation
(1) below; its precise form is in the Appendix.
The coefficients in this equation are constrained to conform with static and
dynamic homogeneity. Static homogeneity ensures that the profit margin is
independent of the price level in a long run equilibrium. Dynamic homo-
geneity ensures that it is independent of the rate of inflation in the long run.
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