We have examined inflation in several blogs in recent months. With inflation at levels not seen for 40 years, this is hardly surprising. One question we’ve examined is whether the policy response has been correct. For example, in July, we asked whether the Bank of England had raised interest rates too much, too late. In judging policy, one useful distinction is between demand-pull inflation and cost-push inflation. Do they require the same policy response? Is raising interest rates to get inflation down to the target rate equally applicable to inflation caused by excessive demand and inflation caused by rising costs, where those rising costs are not caused by rising demand?
In terms of aggregate demand and supply, demand-pull inflation is shown by continuing rightward shifts in aggregate demand (AD); cost-push inflation is shown by continuing leftward/upward shifts in short-run aggregate supply (SRAS). This is illustrated in the following diagram, which shows a single shift in aggregate demand or short-run aggregate supply. For inflation to continue, rather than being a single rise in prices, the curves must continue to shift.
As you can see, the effects on real GDP (Y) are quite different. A rise in aggregate demand will tend to increase GDP (as long as capacity constraints allow). A rise in costs, and hence an upward shift in short-run aggregate supply, will lead to a fall in GDP as firms cut output in the face of rising costs and as consumers consume less as the cost of living rises.
The inflation experienced by the UK and other countries in recent months has been largely of the cost-push variety. Causes include: supply-chain bottlenecks as economies opened up after COVID-19; the war in Ukraine and its effects on oil and gas supplies and various grains; and avian flu and poor harvests from droughts and floods associated with global warming resulting in a fall in food supplies. These all led to a rise in prices. In the UK’s case, this was compounded by Brexit, which added to firms’ administrative costs and, according to the Bank of England, was estimated to cause a long-term fall in productivity of around 3 to 4 per cent.
The rise in costs had the effect of shifting short-run aggregate supply upwards to the left. As well as leading to a rise in prices and a cost-of-living squeeze, the rising costs dampened expenditure.
This was compounded by a tightening of fiscal policy as governments attempted to tackle public-sector deficits and debt, which had soared with the support measures during the pandemic. It was also compounded by rising interest rates as central banks attempted to bring inflation back to target.
Monetary policy response
Central banks are generally charged with keeping inflation in the medium term at a target rate set by the government or the central bank itself. For most developed countries, this is 2% (see table in the blog, Should central bank targets be changed?). So is raising interest rates the correct policy response to cost-push inflation?
One argument is that monetary policy is inappropriate in the face of supply shocks. The supply shocks themselves have the effect of dampening demand. Raising interest rates will compound this effect, resulting in lower growth or even a recession. If the supply shocks are temporary, such as supply-chain disruptions caused by lockdowns during the pandemic, then it might be better to ride out the problem and not raise interest rates or raise them by only a small amount. Already cost pressures are easing in some areas as supplies have risen.
If, however, the fall in aggregate supply is more persistent, such as from climate-related declines in harvests or the Ukraine war dragging on, or new disruptions to supply associated with the Israel–Gaza war, or, in the UK’s case, with Brexit, then real aggregate demand may need to be reduced in order to match the lower aggregate supply. Or, at the very least, the growth in aggregate demand may need to be slowed to match the slower growth in aggregate supply.
Huw Pill, the Chief Economist at the Bank of England, in a podcast from the Columbia Law School (see links below), argued that people should recognise that the rise in costs has made them poorer. If they respond to the rising costs by seeking higher wages, or in the case of businesses, by putting up prices, this will simply stoke inflation. In these circumstances, raising interest rates to cool aggregate demand may reduce people’s ability to gain higher wages or put up prices.
Another argument for raising interest rates in the face of cost-push inflation is when those cost increases are felt more than in other countries. The USA has suffered less from cost pressures than the UK. On the other hand, its growth rate is higher, suggesting that its inflation, albeit lower than in the UK, is more of the demand-pull variety. Despite its inflation rate being lower than in the UK, the problem of excess demand has led the Fed to adopt an aggressive interest rate policy. Its target rate is 5.25% to 5.50%, while the Bank of England’s is 5.25%. In order to prevent short-term capital outflows and a resulting depreciation in the pound, further stoking inflation, the Bank of England has been under pressure to mirror interest rate rises in the USA, the eurozone and elsewhere.
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Questions
- How may monetary policy affect inflationary expectations?
- If cost-push inflation makes people generally poorer, what role does the government have in making the distribution of a cut in real income a fair one?
- In the context of cost-push inflation, how might the authorities prevent a wage–price spiral?
- With reference to the second article above, explain the ‘monetary policy conundrum’ faced by the Bank of Japan.
- If central banks have a single policy instrument, namely changes in interest rates, how may conflicts arise when there is more than one macroeconomic objective?
- Is Russia’s rise in inflation the result of cost or demand pressures, or a mixture of the two (see articles above)?
Prices of used fully electric cars (EVs) are falling in the UK, even though prices of used internal combustion engine (ICE) cars are rising. According to Auto Trader (see the first two articles below), in February 2023 the average price of used petrol cars rose by 3.3% compared with January and the price of used diesel cars rose by 1.4%. But the price of used EVs fell by 9.1%. This follows a fall of 2.1% in January.
But why are used EV prices falling? After all, the last few years has seen a drive to replace ICEs with EVs and hybrids, with many consumers preferring electric cars to petrol and diesel ones. What is more, vehicle excise duty is currently zero for EVs (and will be until 2025) and the sale of new ICEs will be banned from the end of the decade. The answer lies in demand and supply.
On the demand side, many existing and potential EV owners worry about the charging infrastructure. The number of EVs has grown more rapidly than the number of charging points. In 2020 there was one charging point per 16 cars; by 2022 this had worsened to one per 30 cars. Also the distribution of charging points is patchy and there is a lack of rapid and ultra-rapid chargers. Increasingly, people have to queue for access to a charger and this can substantially delay a journey and could mean missed appointments. There were many pictures in the media around Christmas of long queues for chargers at service stations and supermarkets. Poor charging infrastructure can be more of a problem for second-hand EVs, which tend to have a smaller range.
Also on the demand side is the price of fuel. After the Russian invasion of Ukraine and the rise in oil prices, the price of petrol and diesel soared. This increased the cost of running ICE vehicles and boosted the demand for EVs. But the war also drove up the price of natural gas and this price largely determines the wholesale price of electricity. With government subsidies for electricity, this constrained the rise in electricity prices. This made running an EV for a time comparatively cheaper. 
More recently, the price of oil has fallen and with it the price of petrol and diesel. But electricity prices are set to rise in April as government subsidies cease. The cost advantage of running an electric car is likely to disappear, or at least substantially decline.
Another substitute for second-hand EVs is new EVs. As the range of new EVs increases, then anyone thinking about buying an EV may be more tempted to buy a new one rather than a used one. Such demand has also been driven by Tesla’s decision to cut the UK prices of many of it models by between 10% and 13%.
The fall in demand for used EVs is compounded, at least in the short term, by speculation. People thinking of trading in their ICE or hybrid car for a fully electric one are likely to wait if they see prices falling. Why buy now if, by waiting, you could get the same model cheaper?
On the supply side, EV owners, faced with the infrastructure problems outlined above, are likely to sell their EV and buy an ICE or hybrid one instead. This increases the supply of used EVs. This is again compounded by speculation as people thinking of selling their EV do so as quickly as possible before price falls further.
In many other countries, there is much more rapid investment in charging infrastructure and/or subsidies for purchasing not only new but used EVs. This has prevented or limited the fall in price of used EVs.
Articles
- Auto Trader diagnoses used car sector’s ‘robust health’ after February value rise
AM-online, Tom Sharpe (20/2/23)
- Auto Trader: Used car prices UP AGAIN in February but EV prices continue to tumble
Car Dealer, James Baggott (20/2/23)
- Used electric car prices caught in vicious downward cycle as experts warn of trouble ahead
Car Dealer, James Baggott (13/2/23)
- Used EV market needs more support in Spring Budget, says Vehicle Remarketing Association
Car Dealer, Jack Williams (15/2/23)
- Middle classes cannot afford electric cars, warns Vauxhall owner
The Telegraph, Howard Mustoe (23/2/23)
- British drivers are hurtling towards the electric car cliff edge
The Telegraph on msn, Ben Marlow (23/2/23)
- Cars Drivers should be ‘cautious’ when buying a used EV before 2030 car ban – ‘still an issue!’
Express, Felix Reeves (12/2/23)
- Motorpoint revenues accelerate but dealership group issues profit warning as used electric car prices crash
This is Money, Camilla Canocchi (27/1/23)
- Tesla cuts prices by up to a fifth to boost demand
BBC News, Lucy Hooker (13/1/23)
Questions
- Draw a supply and demand diagram to illustrate what has been happening in the market for used EVs.
- How has the price elasticity of (a) demand and (b) supply affected the amount by which used EV prices have fallen?
- Identify substitutes and complements for used electric vehicles. How relevant is the cross-price elasticity of demand for these complements and substitutes in determining price changes of used EVs?
- Draw a diagram to illustrate the effect of speculation on used EV prices.
- What is likely to happen to used EV prices in the months ahead? Explain.
- How are externalities in car usage relevant to government action to influence the market for EVs? What should determine the size of this intervention?
- Devise a short survey for people thinking of buying an EV to determine the factors that are likely to affect their decision to buy one and, if so, whether to buy a new or used one.
Global oil prices (Brent crude) reached $128 per barrel on 9 March, a level not seen for 10 years and surpassed only in the run up to the financial crisis in 2008. Oil prices are determined by global demand and supply, and the current surge in prices is no exception.
A rise in demand and/or a fall in supply will lead to a rise in the price. Given that both demand and supply are relatively price inelastic, such shifts can cause large rises in oil prices. Similarly, a fall in demand or rise in supply can lead to a large fall in oil prices.
These changes are then amplified by speculation. Traders try to get ahead of price changes. If people anticipate that oil prices will rise, they will buy now, or make a contract to buy more in the future at prices quoted today by buying on the oil futures market. This then pushes up both spot (current) prices and futures prices. If demand or supply conditions change, speculation will amplify the reaction to such a change.
What has happened since 2019?
In 2019, oil was typically trading at around $60 to $70 per barrel. It then fell dramatically in early 2020 as the onset of COVID-19 led to a collapse in demand, for both transport and industry. The price fell below $20 in late April (see charts: click here for a PowerPoint).
Oil prices then rose rapidly as demand recovered somewhat but supply chains, especially shipping, were suffering disruptions. By mid-2021, oil was once more trading at around $60 to $70 per barrel. But then demand grew more strongly as economic recovery from COVID accelerated. But supply could not grow so quickly. By January 2022, Brent crude had risen above $80 per barrel.
Then worries began to grow about Russian intentions over Ukraine as Russia embarked on large-scale military exercises close to the border with Ukraine. People increasingly disbelieved Russia’s declarations that it had no intention to invade. Russia is the world’s second biggest producer of oil and people feared that deliberate disruptions to supply by Russia or other countries banning imports of Russian oil would cause supply shortages. Speculation thus drove up the oil price. By 23 February, the day before the Russian invasion of Ukraine, Brent crude had risen to $95.
With the Russian invasion, moves were made by the EU the USA and other countries to ban or limit the purchase of Russian oil. This increased the demand for non-Russian oil.
On 8 March, the USA announced that it was banning the import of Russian oil with immediate effect. The same day, the UK announced that it would phase out the import of Russian oil and oil products by the end of 2022.
The EU is much more dependent on Russian oil imports, which account for around 27% of EU oil consumption and 2/3 of extra-EU oil imports. Nevertheless, it announced that it would accelerate the move away from Russian oil and gas and towards green alternatives. By 8 March, Brent crude had risen to $128 per barrel.
The question was then whether other sources of supply would help to fill the gap. Initially it seemed that OPEC+ (excluding Russia) would not increase production beyond the quotas previously agreed by the cartel to meet recovery in world demand. But then, on 9 March, the UAE Ambassador to Washington announced that the county favoured production increases and would encourage other OPEC members to follow suit. With the announcement, the oil price fell by 11% to £111. But the next day, it rose again somewhat as the UAE seemed to backtrack, but then fell back slightly as OPEC said there was no shortage of oil.
This is obviously an unfolding story with the suffering of the Ukrainian people at its heart. But the concepts of supply and demand and their price elasticity and the role of speculation are central to understanding what will happen to oil prices in the coming months with all the consequences for poverty and economic hardship.
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Questions
- Use a demand and supply diagram to illustrate what has happened to oil prices over the past two years. How has the size of the effects been dependent on the price elasticity of demand for oil and the price elasticity of supply of oil?
- Use a demand and supply diagram to show what has been happening to the price of natural gas over the past two years. Are the determinants similar to those in the oil market? How do they differ (if at all)?
- What policy options are open to governments to deal with soaring energy prices?
- What are the distributional consequences of the rise in energy prices? (see the blog: Rise in the cost of living.)
- Under what circumstances are oil prices over the next six months likely (a) fall; (b) continue rising?
The suffering inflicted on the Ukrainian people by the Russian invasion is immense. But, at a much lower level, the war will also inflict costs on people in countries around the world. There will be significant costs to households in the form of even higher energy and food price inflation and a possible economic slowdown. The reactions of governments and central banks could put a further squeeze on living standards. Stock markets could fall further and investment could decline as firms lose confidence.
Russia is the world’s second largest oil supplier and any disruption to supplies will drive up the price of oil significantly. Ahead of the invasion, oil prices were rising. At the beginning of February, Brent crude was around $90 per barrel. With the invasion, it rose above $100 per barrel.
Russia is also a major producer of natural gas. The EU is particularly dependent on Russia, which supplies 40% of its natural gas. With Germany halting approval of the major new gas pipeline under the Baltic from Russia to Germany, Nord Stream 2, the price of gas has rocketed. On the day of the invasion, European gas prices rose by over 50%.
Nevertheless, with the USA deciding not to extend sanctions to Russia’s energy sector, the price of gas fell back by 32% the next day. It remains to be seen just how much the supplies of oil and gas from Russia will be disrupted over the coming weeks.
Both Russia and Ukraine are major suppliers of wheat and maize, between them responsible for 14% of global wheat production and 30% of global wheat exports. A significant rise in the price of wheat and other grains will exacerbate the current rise in food price inflation.
Russia is also a significant supplier of metals, such as copper, platinum, aluminium and nickel, which are used in a wide variety of products. A rise in their price has begun and will further add to inflationary pressures and supply-chain problems which have followed the pandemic.
The effect of these supply shocks can be illustrated in a simple aggregate demand and supply diagram (see Figure 1), which shows a representative economy that imports energy, grain and other resources. Aggregate demand and short-run aggregate supply are initially given by AD0 and SRAS0. Equilibrium is at point a, with real national income (real GDP) of Y0 and a price index of P0.
The supply shock shifts short-run aggregate supply to SRAS1. Equilibrium moves to point b. The price index rises to P1 and real national income falls to Y1. If it is a ‘one-off’ cost increase, then the price index will settle at the new higher level and GDP at the new lower level provided that real aggregate demand remains the same. Inflation will be temporary. If, however, the SRAS curve continues to shift upwards to the left, then cost-push inflation will continue.
These supply-side shocks make the resulting inflation hard for policymakers to deal with. When the problem lies on the demand side, where the inflation is accompanied by an unsustainable boom, a contractionary fiscal and monetary policy can stabilise the economy and reduce inflation. But the inflationary problem today is not demand-pull inflation; it’s cost-push inflation. Disruptions to supply are both driving up prices and causing an economic slowdown – a situation of ‘stagflation’, or even an inflationary recession.
An expansionary policy, such as increasing bond purchases (quantitative easing) or increasing government spending, may help to avoid recession (at least temporarily), but will only exacerbate inflation. In Figure 2, aggregate demand shifts to AD2. Equilibrium moves to point c. Real GDP returns to Y0 (at least temporarily) but the price level rises further, to P2. (Click here for a PowerPoint of the diagram.)
A contractionary policy, such as raising interest rates or taxes, may help to reduce inflation but will make the slowdown worse and could lead to recession. In the diagram, aggregate demand shifts to AD3. Equilibrium moves to point d. The price level returns to P0 (at least temporarily) but real income falls further, to Y3.
In other words, you cannot tackle both the slowdown/recession and the inflation simultaneously by the use of demand-side policy. One requires an expansionary fiscal and/or monetary policy; the other requires fiscal and/or monetary tightening.
Then there are other likely economic stresses. If NATO countries respond by increasing defence expenditure, this will put further strain on public finances.
Sentiment is a key driver of the economy and prices. Expectations tend to be self-fulfilling. So if the war in Ukraine undermines confidence in stock markets and the real economy and further raises inflationary expectations, this pessimistic mood will tend in itself to drive down share prices, drive up inflation and drive down investment and economic growth.
Articles
- How will Russia’s invasion of Ukraine hit the global economy?
Financial Times, Chris Giles, Jonathan Wheatley and Valentina Romei (25/2/22)
- Ukraine conflict raises the possibility of stagflation
Financial Times, The Editorial Board (25/2/22)
- Five ways the Ukraine war could push up prices
BBC News, Laura Jones (5/3/22)
- Jason Furman cautions against reading too much into the initial market reactions to Russia’s invasion
interest.co.nz, Jason Furman (26/2/22)
- Putin’s war promises to crush the global economy with inflation and much slower growth
Market Watch, Nouriel Roubini (25/2/22)
- Roubini: 6 Financial, Economic Risks of Russia-Ukraine War
ThinkAdvisor, Janet Levaux (25/2/22)
- Fed tightening plans now contending with war, possible oil shock
Reuters, Howard Schneider and Jonnelle Marte (24/2/22)
- The invasion of Ukraine changed everything for Wall Street
CNN, Julia Horowitz (27/2/22)
- Why the Russian invasion will have huge economic consequences for American families
CNN, Matt Egan (24/2/22)
- European gas prices soar and oil tops $105 after Russia attacks Ukraine
Financial Times, Neil Hume, Emiko Terazono and Tom Wilson (24/2/22)
- Five essential commodities that will be hit by war in Ukraine
The Conversation, Sarah Schiffling and Nikolaos Valantasis Kanellos (24/2/22)
- Ukraine: ‘I’m surprised the oil price hasn’t hit US$130 a barrel yet’ – energy trading expert Q&A
The Conversation, Adi Imsirovic (25/2/22)
- Ukraine crisis: Warning UK energy bills could top £3,000 a year
BBC News, Michael Race (25/2/22)
- Putin’s energy shock: The economic realities of invasion
BBC News, Faisal Islam (25/2/22)
- Fears of UK food and fuel prices rising due to war
BBC News, Oliver Smith & Michael Race (26/2/22)
- Ukraine conflict: What is Swift and why is banning Russia so significant?
BBC News, Russell Hotten (27/2/22)
- Ukraine conflict: How reliant is Europe on Russia for oil and gas?
BBC News, Jake Horton & Daniele Palumbo (25/2/22)
- Ukraine crisis complicates ECB’s path to higher rates
Reuters, Francesco Canepa and Balazs Koranyi (24/2/22)
- Russia and the West are moving towards all out economic war
Al Jazeera, Maximilian Hess (24/2/22)
Questions
- If there is a negative supply shock, what will determine the size of the resulting increase in the price level and the rate of inflation over the next one or two years?
- How may expectations affect (a) the size of the increase in the price level; (b) future prices of gas and oil?
- Why did stock markets rise on the day after the invasion of Ukraine?
- Argue the case for and against relaxing monetary policy and delaying tax rises in the light of the economic consequences of the war in Ukraine.
In its latest Commodity Special Feature (pages 43 to 53 of the October 2020 World Economic Outlook), the IMF examines the future of oil and other commodity prices. With the collapse in oil demand during the early stages of the coronavirus pandemic, oil prices plummeted. Brent crude fell from around $60 per barrel in late January to below $20 in April.
However, oil prices then rose somewhat and have typically been between $40 and $45 per barrel since June 2020 – still more than 35% lower than at the beginning of the year (see chart below: click here for a PowerPoint). This rise was caused by a slight recovery in demand but largely by supply reductions. These were the result partly of limits agreed by OPEC+ (OPEC, Russia and some other non-OPEC oil producing countries) and partly of reduced drilling in the USA and the closure of many shale oil wells which the lower prices had made unprofitable.
The IMF considers the future for oil prices and concludes that prices will remain subdued. It forecasts that petroleum spot prices will average $47 per barrel in 2021, up only slightly from the $42 average it predicts for 2020.
On the supply side it predicts that ‘stronger oil production growth in several non-OPEC+ countries, a faster normalization of Libya’s oil production, and a breakdown of the OPEC+ agreement’ will push up supply and push down prices. Even if the OPEC+ agreement holds, the members are set to ease their production cut by nearly 25% at the start of 2021. This rise in supply will be offset to some extent by possibly ‘excessive cuts in oil and gas upstream investments and further bankruptcies in the energy sector’.
On the demand side, the speed of the recovery from the pandemic will be a major determinant. If the second wave is long-lasting and deep, with a vaccine available to all still some way off, oil demand could remain subdued for many months. This will be compounded by the accelerating shift to renewable energy and electric vehicles and by government policies to reduce CO2 emissions.
Report
Articles
Oil price data
Questions
- Describe a scenario in which oil prices rebound significantly over the coming months. Illustrate your answer with a supply and demand diagram.
- Describe a scenario in which oil prices fall over the coming months. Again, illustrate your answer with a supply and demand diagram.
- How are the price elasticities of demand and supply relevant to the size of any oil price change?
- Project forward 10 years and predict whether oil prices will be higher or lower than now. What are the major determinants of supply and demand in your prediction?
- What are oil futures? What determines oil future prices?
- How does speculation affect oil prices?
Inflation: Not Dead Yet