By Clare Macallan and Miles Parker of the Bank's Structural Economic Analysis Division.
The Monetary Policy Committee's (MPC's) objective is to deliver price stability. In order to achieve that goal, it is necessary to understand how inflation reacts to economic events. In the long run, inflation is determined by monetary policy. But over a shorter time horizon, one important determinant of changes in inflation is the gap between the prices charged by businesses and the costs that they face: that 'mark-up' will influence how changes in demand relative to supply feed through into consumer price inflation. The evidence presented in this article suggests that mark-ups vary positively with excess demand. That will increase the sensitivity of inflation to changes in excess demand. But it could also increase the efficacy of monetary policy, since the level of excess demand is in part determined by the level of Bank Rate set by the MPC.