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Articles for the ‘Essentials of Economics 6e: Ch 08’ Category

US rates: the dilemma

Interest rates are the main tool of monetary policy and have a history of being an effective tool in creating macroeconomic stability. There has been much discussion since the end of the financial crisis concerning when interest rates would rise in the US (and the UK) and for the US, the case is stronger, given its rate of growth, which has averaged at 2.2% per annum since June 2009.

As in the UK, the question of ‘will rates rise?’ has a clear and certain answer: Yes. The more challenging question is ‘when?’. Much of the macroeconomic data for the US is promising, with positive economic growth (and relatively strong in comparison to the UK and Eurozone), a low unemployment rate and inflation of 0.3%. This last figure is ‘too low’, but it comes in at a much more attractive 1.2% if you exclude food and energy costs and there is an argument for doing this, given the price of oil. The data on unemployment and growth might suggest that the economy is at a stage where a rate rise could be managed, but the inflation data indicates that low interest rates might be needed to keep inflation above 0%. Furthermore, there are concerns that the low unemployment figure is somewhat misleading, given that under-employment is quite high at 10.3% and there are still many who are long-term unemployed, having been out of work for more than 6 months.

Interest rates can be a powerful tool in affecting the components of aggregate demand (AD) and hence the macroeconomic variables. If interest rates fall, it can help to stimulate AD by reducing borrowing costs for consumers and businesses, reducing the incentive to save, cutting variable rate mortgage payments and depreciating the exchange rate. Collectively these effects can stimulate an economy and hence create economic growth, reduce unemployment and push up prices. However, interest rates have been at almost 0% since the financial crisis, so the only way is up. Reversing the aforementioned effects could then spell trouble, if the economy is not in a sufficiently strong position.

For many, the strength of the US economy, while relatively good, is not yet good enough to justify a rate rise. It may harm investment, growth and unemployment and none of these variables are sufficiently high to warrant a rate rise, especially given the slowdown in the emerging markets. Karishma Vaswani, from BBC News said:

“The current global hand-wringing and head-holding over whether the US Fed will or won’t raise interest rates later has got investors here in Asia worried about what this means for their economies.
The Fed has become the favourite whipping boy of Asia’s central bankers, with cries from India to Indonesia to “just get on with it”.”

There are many, including Professor John Taylor from Stanford University and a former senior Treasury official, a rate rise is well over-due. The market is expecting one and has been for some time and these expectations aren’t going away, so ‘just get on with it.’ Janet Yellen, the Chair of the Federal Reserve is in a tricky situation. She knows that whatever is decided, markets around the world will react – no pressure then! The following articles consider the interest rate debate.

FTSE slides ahead of Fed interest rates decision The Telegraph, Tara Cunningham (17/9/15)
US’s interest rate rise dilemma BBC News, Andrew Walker (17/9/15)
US interest rate rise: how it could affect your savings and your mortgage Independent (17/9/15)
All eyes on Federal Reserve as it prepares for interest rate announcement The Guardian, Rupert Neate (16/9/15)
Federal Reserve meeting: Will US interest rates rise and should they? The Telegraph, Peter Spence (16/9/15)
Markets push US rate rise bets into 2016 as China woes keep Fed on hold: as it happened The Telegraph, Szu Ping Chan (17/9/15)
Federal Reserve puts rate rise on hold The Guardian (17/9/15)
US central bank leave interest rates unchanged BBC News (17/5/15)
Fed leaves interest rates unchanged Wall Street Journal, Jon Hilsenrath (17/9/15)
Asian markets mostly rally, US Futures waver ahead of Fed interest rate decision International Business Times, Aditya Tejas (17/9/15)

Selected US interest rates Board of Governors of the Federal Reserve System (see, for example, Federal Funds Effective rate (monthly))


  1. What happened to US interest rates in September?
  2. Present the main arguments for keeping interest rates on hold.
  3. What were the arguments in favour of raising interest rates and do they differ depending on whether interest rates rise slowly or very rapidly?
  4. How did stock markets around the world react to Janet Yellen’s announcement? Is it good news for the UK?
  5. Using a diagram to support your explanation, outline why interest rates are such a powerful tool of monetary policy and how they affect the main macroeconomic objectives.
  6. Do you think other central banks will take note of the Fed’s decision, when they make their interest rate decisions in the coming months? Explain your answer.
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A chill wind from the east

The mood has changed in international markets. Investors are becoming more pessimistic about recovery in the world economy and of the likely direction of share prices. Concern has centred on the Chinese economy. Forecasts are for slower Chinese growth (but still around 5 to 7 per cent) and worries centre on the impact of this on the demand for other countries’ exports.

The Chinese stock market has been undergoing turmoil over the past few weeks, and this has added to jitters on other stock markets around the world. Between the 5th and 24th of August, the FTSE 100 fell by 12.6%, from 6752 to 5898; the German DAX fell by 17.1% from 11,636 to 9648 and the US DOW Jones by 10.7% from 17,546 to 15,666. Although markets have recovered somewhat since, they are very volatile and well below their peaks earlier this year.

But are investors right to be worried? Will a ‘contagion’ spread from China to the rest of the world, and especially to its major suppliers of raw materials, such as Australia, and manufactured exports, such as the USA and Germany? Will other south-east Asian countries continue to slow? Will worries lead to continued falls in stock markets as pessimism becomes more entrenched? Will this then impact on the real economy and lead then to even further falls in share prices and further falls in aggregate demand?

Or will the mood of pessimism evaporate as the Chinese economy continues to grow, albeit at a slightly slower rate? Indeed, will the Chinese authorities introduce further stimulus measures (see the News items What a devalued yuan means to the rest of the world and The Shanghai Stock Exchange: a burst bubble?), such as significant quantitative easing (QE)? Has the current slowing in China been caused, at least in part, by a lack of expansion of the monetary base – an issue that the Chinese central bank may well address?

Will other central banks, such as the Fed and the Bank of England, delay interest rate rises? Will the huge QE programme by the ECB, which is scheduled to continue at €60 billion until at least September 2016, give a significant boost to recovery in Europe and beyond?

The following articles explore these questions.

The Guardian view on China’s meltdown: the end of a flawed globalisation The Guardian, Editorial (1/9/15)
Central banks can do nothing more to insulate us from the Asian winter The Guardian, Business leader (6/9/15)
Where are Asia’s economies heading BBC News, Karishma Vaswani (4/9/15)
How China’s cash injections add up to quantitative squeezing The Economist (7/9/14)
Nouriel Roubini dismisses China scare as false alarm, stuns with optimism The Telegraph, Ambrose Evans-Pritchard (4/9/15)
Markets Are Too Pessimistic About Chinese Growth Bloomberg, Nouriel Roubini (4/9/15)

World Economic Outlook databases IMF: see, for example, data on China, including GDP growth forecasts.
Market Data Yahoo: see, for example, FTSE 100 data.


  1. How do open-market operations work? Why may QE be described as an extreme form of open-market operations?
  2. Examine whether or not the Chinese authorities have been engaging in monetary expansion or monetary tightening.
  3. Is an expansion of the monetary base necessary for there to be a growth in broad money?
  4. Why might the process of globalisation over the past 20 or so years be described a ‘flawed’?
  5. Why have Chinese stock markets been so volatile in recent weeks? How seriously should investors elsewhere take the large falls in share prices on the Chinese markets?
  6. Would it be fair to describe the Chinese economy as ‘unstable, unbalanced, uncoordinated and unsustainable’?
  7. What is the outlook over the next couple of years for Asian economies? Explain.
  8. For what reasons might stock markets have overshot in a downward direction?
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Uncertainty and the EU Referendum

Interest rates are the main tool of monetary policy and crucially affect investment. There has been much discussion since the end of the financial crisis concerning when UK interest rates would eventually rise. Uncertainty over just when, and by how much, interest rates will rise affects business confidence and hence investment. Businesses therefore listen carefully to what the Bank of England says about future movements in Bank Rate. But Mark Carney has now spoken about another cause of uncertainty and its impct on investment. This is the uncertainty over the outcome of the referendum on whether the UK should leave the EU.

By 2017, the Prime Minister has promised a referendum on staying in the EU, but Mark Carney has urged for this to be held ‘as soon as possible’. Whether or not the UK remains in the EU will have a big effect on businesses and with the uncertainty surrounding the UK’s future, this may soon turn to a lack of investment. As yet, businesses have not responded to this uncertainty, but the longer the delay for the referendum, the more inclined firms will be to postpone investment. As Mark Carney said:

“We talk to a lot of bosses and there has been an awareness of some of this political uncertainty – whether because of the election or because of the referendum … What they’ve been telling us, and we see it in the statistics, is they have not yet acted on that uncertainty – or to put it another way, they are continuing to invest, they are continuing to hire.”

Leaving the EU will have big effects on consumers and businesses, given that the EU is the UK’s largest market, trading partner and investor. With a referendum sooner rather than later, uncertainty will be more limited and any reaction by businesses will take place over a shorter time period. There are many other factors that affect business investment, some of which are related to the UK’s relationship with the EU and the following articles consider these issues.

EU referendum should be held ‘as soon as necessary’, says Mark Carney BBC News (14/5/15)
Business want an early EU referendum, Mark Carney indicates The Telegraph, Ben Riley-Smith (14/5/15)
EU poll should take place ‘as soon as necessary’, says Bank of England Chief The Guardian, Angela Monaghan (14/5/15)
Threat of business leaving the EU is fuelling business ‘uncertainty’, says Bank of England governor Mark Carney Mail Online, Matt Chorley (14/5/15)
Bank of England’s Mark Carney urges speedy EU referendum Financial Times, George Parker (14/5/15)


  1. Why is the EU important to the UK’s economic performance?
  2. If the UK were to leave the EU, what impact would this have on UK consumers?
  3. What would be the impact on UK firms if the UK were to leave the EU?
  4. Consider an AD/AS diagram and use this to explain the potential impact on the macroeconomic variables if the UK were to leave the EU.
  5. Why is uncertainty over the UK’s referendum likely to have an adverse effect on investment?
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Insolvencies down – lessons learned?

Insolvencies in England and Wales have fallen to their lowest level since 2005, official records show. The Insolvency Service indicates that bankruptcy, individual voluntary arrangements and debt relief orders have fallen, with the largest and worst form of bankruptcy falling by 22.5 per cent compared to the same period in 2014. There has also been a fall in corporate insolvencies back to pre-crisis levels.

The British economy is recovering and despite an increase in consumer borrowing of £1.2 billion from February to March, which is the biggest since the onset of the credit crunch, the number of people in financial difficulty and living beyond their means has fallen. However, there are also suggestions that the number could begin to creep up in the future and we are still seeing a divide between the north and south of England in terms of the number of insolvencies.

There are many factors that could explain such a decline in insolvencies. Perhaps it is the growth in wages, in part due the recovery of the economy, which has enabled more people to forgo borrowing or enabled them to repay any loan more comfortably. Lower inflation has helped to reduce the cost of living, thereby increasing the available income to repay any loans. Interest rates have also remained low, thus cutting the cost of borrowing and the repayments due.

But, another factor may simply be that lending is now more closely regulated. Prior to the financial crisis, huge amounts of money were being lent out, often to those who had no chance of making the repayments. More stringent affordability checks by lenders may have a large part to play in reducing the number of insolvencies. President of R3, the insolvency practitioner body, Phillip Sykes said:

“It may be too early to draw conclusions but demand could be falling as a result of low interest rates, low inflation and tighter regulation. This trend is worth watching.”

Mark Sands, from Baker Tilly added to this, noting that fewer people were now in financial difficulty.

“As well as this, we are seeing lower levels of personal debt and fewer people borrowing outside of their means due to more stringent affordability checks by creditors.”

Whatever the main reason behind the data, it is certainly a positive indicator, perhaps of economic recovery, or that at least some have learned the lessons of the financial crisis. The following articles consider this topic.

Personal insolvencies fall to 10-year low Financial Times, James Pickford (1/5/15)
Personal insolvencies at lowest level since 2005 BBC News (29/4/15)
Personal insolvencies drop to lowest level in a decade The Guardian, Press Association (29/4/15)
Corporate insolvencies at lowest level since 2007 The Telegraph, Elizabeth Anderson (30/4/15)
Interview: R3 President Phillip Sykes Accountancy Age, Richard Crump (1/5/15)
North-South gap widens in personal insolvencies Independent, Ben Chu (27/4/15)
Insolvency rates show ‘stark’ north-south divide Financial Times, James Pickford (27/4/15)


  1. What is meant by insolvency?
  2. There are many factors that might explain why the number of insolvencies has fallen. Explain the economic theory behind a lower inflation rate and why this might have contributed to fewer insolvencies.
  3. How might lower interest rates affect both the number of personal and corporate insolvencies?
  4. Why has there been a growth in the north-south divide in terms of the number of insolvencies?
  5. Do you think this data does suggest that lessons have been learned from the Credit Crunch?
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Nigeria: An African success story?

A new group of economies, known as MINT, are seen as strong current and future emerging markets. We’ve had the BRICS (Brazil, Russia, India, China and South Africa) and now we have the MINTs (Mexico, Indonesia, Nigeria and Turkey).

In 2014, Nigeria became Africa’s fastest growing nation. A large part of Nigeria’s success has to do with growth in some of its key industries.

Nigerian’s reliance on the oil and gas industry created an attractive economy for further development and it now has high growth in a diverse range of sectors, including mobile phones, champagne, private jets and ‘Nollywood’. Despite the uncertainty and political unrest caused by Boko Haram, Nigeria is attracting a significant amount of Foreign Direct Investment (FDI) in a range of sectors, indicating its growing diversity and attractiveness to some of the world’s largest multinational companies.

Boko Haram has certainly had a dampening effect on Nigeria’s growth, as has the lower oil price, but this may create opportunities for further diversification. Furthermore there are concerns about how the wealth of the nation is concentrated, given that poverty is still prevalent across the country. However, Nigeria is certainly emerging as a success story of Africa and surely the question that will be asked is will other African nations follow suit?

The following article from BBC News considers the Nigerian economy.

Nigeria’s ‘champagne’ economy bucks Boko Haram effect BBC News, Vishala Sri-Pathma (27/3/15)


  1. Is a falling oil price necessarily bad for the Nigerian economy?
  2. Explain why Boko Haram is likely to have a dampening effect on economic growth in Nigeria.
  3. Do you think other African nations will be able to replicate the success of Nigeria? Which factors may prevent this?
  4. If the number of millionaires is increasing significantly, but poverty is persisting, does this tell us anything about what is happening to inequality in Nigeria?
  5. Is is possible to reduce inequality in Nigeria while maintaining economic growth? Might it even be posible for greater equality to be a driver of economic growth?
  6. The Nigerian currency is weakening. What has caused this and why may this be a cause for concern?
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The falling pound

With an election approaching in the UK, uncertainty is a term we will hear frequently over the next few weeks. Until we know which party or parties will be in power and hence which policies will be implemented, planning anything is difficult. This is just one of the factors that has caused the British pound sterling to fall last week by 2% to an almost five year low against the dollar.

In the last election, uncertainty also prevailed and continued even after the election before the Coalition was formed. Given how close this election appears to be at present, another Coalition may have to be formed and this is adding to the current election uncertainty. A currency strategist at Standard Bank said:

“A $1.40 level for sterling/dollar is certainly not out of reach if the election aftermath turns ugly”

With such uncertainty, investors are refraining from putting their money into the UK and this has contributed towards the deprecation of the British pound against the dollar.

Another factor adding to this downward pressure on the pound is the latest data on industrial output. Although economic growth figures for the UK in 2014 were very positive, there are some suggestions that 2015 will not be as good as expected, though still a strong performance. The first quarter data will not be available until just before the election, but data from the ONS on industrial output shows very minimal growth at just 0.1% from January to February. Chris Williams at Markit said:

“Clearly this all bodes ill for economic growth in the opening quarter of the year. It’s now looking like the economy slowed, and possibly quite markedly, compared to the 0.6% expansion seen in the closing quarter of 2014 … The trend should improve in March, however, according to survey data.”

These two factors have combined to push the pound down, with investors preferring to hold their money in dollars, despite the weak US unemployment data. However, it is not only against the dollar that we must consider sterling’s performance. Against the euro, it has performed better, rising by 1.5%. Whether this is positive for the UK or very negative for the Eurozone is another question. The following articles consider the performance of the British pound.

Sterling falls to five-year low Financial Times, Neil Dennis (10/4/15)
Sterling plummets to five year low as economic slowdown looms The Telegraph, Mehreen Khan (10/4/15)
Pound at five-year low against dollar on weak output BBC News (10/4/15)
Sterling falls after Bank of England’s Haldane says even chances of rate cut or rise Reuters (10/4/15)
Pound falls to five-year low as volatility jumps before election Bloomberg, Anooja Debnath and David Goodman (11/4/15)
Pound falls to a five-year low against the dollar as polls suggest election will create economic uncertainty Mail Online, Matt Chorley (10/4/15)


  1. Draw a diagram illustrating the way in which the $/£ exchange rate is determined.
  2. Explain why the election is causing economic uncertainty in the UK.
  3. How would uncertainty affect the demand and supply of sterling and hence the exchange rate?
  4. US job data is worse than expected. Shouldn’t this have caused the dollar to depreciate against the pound and not appreciate?
  5. Industrial output data for the UK economy is lower than expected. What has caused this?
  6. Why does slower growth in industrial output cause the exchange rate to depreciate?
  7. In order to keep the UK’s inflation rate on target, Haldane has said that we could expect a cut or rise in interest rates and policy should be prepared for both. How has this affected the exchange rate?
  8. Are there any advantages of having a lower pound?
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Interpreting economic data at election time

The UK general election is on May 7. In the campaign during the run-up to the election the economy will be a major issue. All parties will use economic data to claim that the economy has performed well or badly and that the prospects are good or bad. As economics students you will, no doubt, be asked to comment on these claims by your friends. So where can you get analysis of the data that is not biased towards one party or another?

One source is the Institute for Fiscal Studies. It is respected by politicians of all parties as an impartial presenter and analyser of economic data. In fact, it is fiercely independent. But at election time, when often quite dramatic claims are made by politicians, the IFS often comments on whether the data support such claims.

An example occurred when David Cameron claimed that if Labour were elected, working families would face a £3028 tax rise to fund the party’s spending commitments. The IFS said that the claim was misleading as, even on the Conservatives’ assumptions, it was was based on the cumulative increase over five years, not the annual increase, and was not per household but only per working household. The IFS also said that the Conservatives’ assumptions were wrong and not in accordance with the Charter for Budget Responsibility, with which the Labour party agreed.

Expect the IFS to criticise more claims as the election campaign progresses: not just by the Conservative party but by the other parties too. After all, the IFS is not partisan and is prepared to challenge false economic claims from whatever party. Expect also that the political parties will cherry pick whatever statements by the IFS seen to favour them or criticise their opponents.

You can also expect political bias in the newspapers that report the campaigns. Even when they present facts, how they present them and which facts they choose to include and which to ignore will be a reflection of their political bias. So even newspaper reporting of what the IFS says is likely to be selective and nuanced!

Why IFS boss Paul Johnson counts in this tightest of general elections The Guardian, Larry Elliott (30/3/15)
David Cameron’s claim that Labour would raise taxes by £3,000 is ‘not sensible’, says the IFS Independent, Jon Stone (30/3/15)
‘tax rise’ is shot down by IFS The Guardian, Patrick Wintour (30/3/15)
We will borrow more if we win the election, Labour admits The Telegraph, Christopher Hope (29/3/15)
Chancellor accused of U-turn on austerity: Top economist says £20bn fiscal boost lurking in Budget is ‘remarkable reversal’ This is Money, Hugo Duncan (19/3/15)


  1. Distinguish between positive and normative statements. How might politicians blur the distinction in their claims and counter-claims?
  2. Identify three series of macroeconomic data from at least two independent organisations. For what reasons might the data be (a) unreliable; (b) used by political parties to mislead the electorate?
  3. In what ways can political parties use economic data to their own advantage without falsifying the data?
  4. How may public-sector deficit and debt statistics be interpreted in ways to suit (a) the current government’s case that the public finances have been well managed; (b) the opposition case that the public finances have been badly managed?
  5. Use data to analyse an economic claim by each of at least three political parties and the extent to which the claims are accurate.
  6. The above links are to articles from four UK national newspapers: The Guardian, the Independent, The Telegraph and the Daily Mail (This is Money). Identify political bias in the reporting in each of the articles.
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Ending global poverty

In the developed countries of 2015, extreme poverty is (or should be) a thing of the past. With well-developed welfare states and hence safety nets, no-one should be living in deep poverty. However, that is not the case across the rest of the world, where extreme poverty is still a common thing – though much reduced compared to a decade ago.

In the article linked below, Linda Yueh of the BBC asks whether it is possible to end global poverty. Looking at some of the key data, we are certainly moving in the right direction, with the poverty rate in the developing world halving since 1981. Projections suggest that ending global poverty by 2030 is possible, though it will require significant investment and commitment. The World Bank data indicates that 50 million people would need to be brought out of poverty every year. Economists, on the other hand, suggest that the poverty rate may have fallen to around 8% – still progress, but perhaps a more realistic target?

How we measure poverty is clearly important here, as the higher the threshold income required to be ‘out of poverty’, the longer it will take and the more people will currently be in poverty. It is also important to consider things like changes in the population as although more people may be brought out of poverty, if an even greater number of people are being born in a country, then it is entirely possible that poverty actually increases in absolute terms.

A key thing to bear in mind when it comes to reducing poverty is that there is no ‘one size fits all’ policy. What works in one country is not necessarily going to work in another country. Policies will have to be targeted to the needs of the population and this means more time and resources. The numbers are definitely moving in the right direction, but whether they are going quickly enough to meet the 2030 target is another story. The BBC News article is linked below, as are some interesting documents and items from the World Bank and United Nations.

Is it possible to end global poverty? BBC News, Linda Yueh (27/3/15)
Poverty will only end by 2030 if growth is shared World Bank, Espen Beer Prydz (19/11/14)
Far greater effort needed to eradicate extreme poverty in world’s poorest nations United Nations News Centre (23/10/14)
Ending Poverty and Sharing Prosperity World Bank Group and International Monetary Fund, Global Monitoring Report 2014/2015 2015


  1. What is poverty and how to we measure it?
  2. If the growth rate of the world is high, does this mean that poverty is falling?
  3. What factors have explained the success of China in reducing poverty? Why might similar policies be ineffective in Africa? What types of policies would you recommend to reduce global poverty in Sub-Saharan Africa?
  4. Does Aid or Debt Forgiveness from developed countries help poorer nations or could it create a moral hazard?
  5. How important is economic growth in eliminating global poverty?
  6. How important are the Millennium Development Goals in driving efforts to eradicate global poverty?
  7. What are the 3 elements that the Global Monitoring Report focuses on to make growth inclusive and sustainable? In each case, explain how the elements would contribute towards global efforts to end poverty.
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Fuelling the absence of inflation

The latest inflation figures, as detailed in February’s Consumer Price Inflation Statistical Bulletin, show that the annual rate of CPI inflation hit zero in February. This is down from 0.3 per cent in January. While inflation is now well outside the 1-3 per cent target range that the Bank of England is charged with meeting, perhaps a more pertinent question is whether the UK is teetering on the brink of deflation – and the risks that may carry.

To get a better sense of the latest inflation picture we need to delve deeper into the numbers and look at the patterns in the prices that make up the overall Consumer Price Index. Interestingly, these shows that five of the 12 principal product groups that make up the index are currently experiencing price deflation.

As explained in Consumer Price Inflation: The 2015 Basket of Goods and Services, produced by the ONS, around 180,000 prices quotations are collected each month for around 700 representative items. These goods and services fall into one of 12 broad product groups. These include, for example, food and non-alcoholic beverages and transport.

The items included in each of the 12 product groups are reviewed once a year so that the chosen items remain representative of today’s spending patterns. A monthly price index is calculated for these 12 broad groupings, known as divisions, and for sub-categories of these. For example meat is a category within food and non-alcoholic beverages. The overall CPI is a weighted average of the 12 broad groupings.

The annual rate of CPI inflation in February 2015 was zero. This means that the price of the representative basket of goods and services was unchanged from its level in February 2014. As Chart 1 shows (click here for a PowerPoint of the chart), the annual rate of CPI inflation series goes back to January 1989 and this is the first time it has fallen to zero. Its average over this period is in fact 2.7 per cent. The recent fall is quite stark with the rate of CPI inflation in June 2013 close to the top-end of the Bank of England’s target range at 2.9 per cent.

Of the 12 product groups, five constitute 10 per cent or more of the overall weight of the CPI index. These weights are dependent on the relative level of expenditure comprised by each division.

Chart 2 shows the annual rates of inflation for these five groups (click here for a PowerPoint of the chart). The most heavily-weighted component is transport (14.9%), which includes the price of fuel and passenger transport. Here we observe deflation with prices 2.7 per cent lower year-on-year in February. This is the fourth consecutive month where its annual rate of price inflation has been negative.

The second most heavily-weighted component within the CPI index is recreation and culture (14.7%), which includes games, toys and audio-visual equipment. Here too we see the emergence of deflation. In February 2015 prices were 0.8 per cent lower than in February 2014. Deflation is most prevalent in the fifth most heavily-weighted component (11.0%): food and non-alcoholic drinks. The price for this division of the CPI was 3.3 per cent lower in February 2015 as compared with February 2014. In nine of the last ten months the price of food and non-alcoholic drinks, helped by aggressive price competition in the grocery sector, has been lower year-on-year.

February also saw a negative annual rate of inflation emerge for the first time in the CPI division capturing furniture and household equipment and appliances (-0.3 per cent). Further, miscellaneous services, which include personal care and personal effects (e.g. jewellery) saw an annual rate of deflation for the eight consecutive month. The annual rate of inflation for miscellaneous services stood at -0.4 per cent in February. However, February did see an upturn in price inflation for clothing and footwear with prices 1.7 per cent higher than a year earlier while the price of alcohol and tobacco was 3.8 per cent higher year-on-year.

The detailed inflation numbers do reveal the extent to which many CPI divisions are already characterised by deflation. It is interesting to note that in A Comparison of Independent Forecasts published monthly by HM Treasury, the forecast for the final quarter of 2015 is for the annual rate of CPI inflation to be running at 0.8 per cent. An important reason for this is that the effect of falling fuel prices from November 2014 will begin to drop out of the year-on-year inflation rate calculations. The removal of this effect should help to prevent the specter of deflation provided that peoples’ inflationary expectations remain anchored, i.e. exhibit stickiness. If these were to be revised down, however, this would further contribute to downward pressure on prices since input price inflation – including wage inflation – would again be expected to fall.

U.K. on Brink of Falling Prices as Inflation Rate Drops to Zero Bloomberg, Tom Beardsworth (24/3/15)
UK inflation rate falls to zero in February BBC News (24/3/15)
Britain sees no inflation in February for first time on record Reuters, David Milliken and Andy Bruce (24/3/15)
Inflation hits a record zero boosting household incomes Independent, Clare Hutchinson (24/3/15)
Inflation Hits 0% As Food Costs Fall Further Sky News (24/3/15)
Inflation falls to zero in February as Britain heads to deflation Telegraph, Szu Ping Chan (24/3/15)
UK inflation hits zero for the first time on record Guardian, Angela Monaghan (24/3/15)

Consumer Price Inflation, February 2015 Office for National Statistics
Consumer Price Indices, Time Series Data Office for National Statistics


  1. Explain the difference between a decrease in the level of prices and a decrease in the rate of price inflation. Can the rate of price inflation rise even if price levels are falling? Explain your answer
  2. Explain what is meant by deflation.
  3. In what ways might deflation affect the behaviour of people? What effect could this have on the macroeconomy?
  4. Why do you think policy-makers, such as the Monetary Policy Committee, would be interested in the inflation rates within the overall CPI inflation rate?
  5. What factors do you think lie behind the fall in the transport component of the CPI?
  6. Explain why the rate of inflation would be expected to rise in the late autumn, a year on from when the transport component of the CPI began falling.
  7. Does the possibility of deflation mean that inflation rate targeting has failed?
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The fate of the eurozone

The eurozone is certainly in trouble and, despite the efforts of world leaders to create confidence, it appears that most announcements are having the opposite effect. The risk of deflation has now emerged to be very true; the powerhouse of Europe ‘needs to do more’ and the euro has fallen following Mario Draghi’s recent comments. So, just how bad are things in the eurozone?

Mario Draghi suggested that as a means of stimulating the eurozone economies, a process of quantitative easing may soon need to begin. However, rather than reassuring investors that action was being taken to improve the economic performance in the region, it appears to have had the opposite effect. Following his comments, the euro fell to its lowest level since the middle of 2010.

Quantitative easing has seen much use in the aftermath of the financial crisis and the aim in the eurozone would be to put a stop to the continuing price decreases. The eurozone has now entered deflation and, while the aim of this economic area has always been low prices, deflation is not good news. The downward pressure on prices has been largely driven by oil prices falling and prices in other areas remaining relatively stable.

Quantitative easing would inject money into the eurozone, thus creating growth (or at least that’s the idea) and pushing up prices. One of Mario Draghi’s comments was:

‘We are making technical preparations to alter the size, pace and composition of our measures in early 2015.’

So, while it’s not certain that the QE policy will be used, it seems pretty likely, especially as this policy has been floating around for almost a year.

A key question is, will it work? The quantity theory of money does suggest that an increase in the money supply will lead to inflationary pressures, unless its velocity of circulation falls. But will it actually stimulate aggregate demand and economic growth? If there is more money in the banking system and hence more money available for lending then it may well stimulate investment and consumption. However, if consumers and firms are not confident about the effectiveness of the policy or about the future of the economy, then will the fact that more money is available for lending actually encourage them to borrow? In this case will there merely be a fall in the velocity of circulation?

The comments by Mario Draghi have also caused the euro to fall to its lowest level since 2010. The graph included in the CNBC article provides an interesting view of the path of the euro. Marc Chandler, from Brown Brothers Harriman said:

‘I’d say there’s a good chance it [the euro] gets there [parity with the dollar] before the election next November (2016) … We know the Fed’s going to be raising rates sooner or later, and the ECB is going to be easing sooner or later. I just see a steady grind lower.’

The outlook of the euro therefore doesn’t look too good by all accounts. It is now a waiting game to see if the policy of quantitative easing is implemented and whether or not it has the desired effect. The following articles consider this topic.

Eurozone economy slows further BBC News (6/1/15)
Eurozone falls into deflation for first time since October 2009 Financial Times, Claire Jones (7/1/15)
Eurozone officially falls into deflation, piling pressure on ECB The Telegraph, Marion Dakers (7/1/15)
Eurozone consumer prices fall for first time in five years Nasdaq, Brian Blackstone and Paul Hannon (7/1/15)
Draghi comments send euro to lowest level since 2010 BBC News (2/1/15)
Oil slump drags Eurozone into deflation The Guardian, Graeme Wearden (7/1/15)
Eurozone prices fall more than expected in December Reuters (7/1/15)
Eurozone lurches into deflation after oil price crashes Independent, Russell Lynch (7/1/15)
German inflation hits five-year low as Eurozone prepares for QE The Telegraph, Mehreen Khan (5/1/15)
Euro slide could take it to parity with dollar CNBC, Patti Domm (7/1/15)


  1. Why is deflation a cause for concern when normally the main problem is inflation that is too high?
  2. What is the quantity theory of money and how does it suggest an increase in the money supply will affect prices?
  3. If quantitative easing is implemented, is it likely to have the desired effect? Explain why or why not.
  4. Why has the euro been affected by Mario Draghi’s comments? Use a diagram to help your explanation.
  5. How will quantitative easing help to stimulate economic growth across the Eurozone? Are there any other policies that would be effective?
  6. Oil prices have had a big influence on the deflationary pressures in the Eurozone. If oil prices increased again, would this be sufficient to create inflation?
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