Magazine article Management Today

How to Damp Down Demand

Magazine article Management Today

How to Damp Down Demand

Article excerpt

HOW TO DAMP DOWN DEMAND

The hike of interest rates to 13% coincided, as did the previous rise to 12%, with unexpectedly bad balance of payments figures. On each occassion the Chancellor of the Exchequer said that the problem was not the balance of payments as such, but the evidence that demand was growing too rapidly. We have seen base rates raised from their low point of 7 1/2% last May to 13% in an attempt to damp down demand and avoid the risks of inflation. How serious is the risk, and has enough been done to head it off?

Much time and effort used to be spent on the question of whether inflation was caused by `demand-pull' or `cost-push'. The former was allegedly caused by an excessive growth of demand which `pulled up' prices, while the latter was caused by cost pressures (either wages or raw materials) which `pushed up' prices. In retrospect the debate seems rather pointless, since it is virtually impossible to distinguish between the two processes either in theory or practice. For example, the fact that wage increases may have preceded price increases does not tell us that it was a cost-push inflation since employees may rightly have perceived that prices were about to accelerate (in response to some independent cause).

In the case of the UK it is fairly clear that demand conditions are what have given rise to potential problems of inflation, and there are at least three sources of evidence for this view. The first is that the acceleration of inflation was preceded by an acceleration of money and credit. The second is that domestic demand has grown considerably more rapidly than supply, and the third is that prices have grown more rapidly than costs.

I shall return to those three pieces of evidence, but initially we can consider what evidence there is so far that inflation has actually accelerated. The first chart shows the retail price index, which is the most generally accepted measure of inflation. The index is, however, highly sensitive to changes in mortgage rates, and the chart shows the RPI including and excluding mortgages. It shows that the peak in 1985 and the trough in 1986 were associated with changes in the mortgage rate. Similarly the present peak owes much to the recent rises in the mortgage rate. The chart also shows that the inflation rate has been accelerating since the beginning of 1988.

The causes of this rise in inflation lie in developments since the middle of 1987. At that point the growth of credit started to accelerate and the results showed up in the growth of the broad measures of the money supply. By the end of the year the growth of narrow money (MO) was also accelerating and starting to move out of its target range. In part this was because the UK, like all the major industrial nations, was relaxing its monetary policy in reaction to fears about the possible consequences of Black Monday. But Britain took this process further than most, and then during the spring of 1988 it relaxed policy still further in an attempt to prevent an appreciation of the exchange rate.

This relaxation of policy had two consequences. The first was that domestic demand grew very rapidly (though the official statistics are in some disarray) and the trade balance deteriorated sharply. The trade balance, in effect, acted as a safety valve to relieve the pressure of domestic demand. The second was that firms were able to raise prices and margins. …

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