costs and effects of inflation

There is widespread agreement that high and volatile inflation can be damaging both to individual businesses and consumers and also to the economy as a whole.

However, economists disagree about the relative seriousness of inflation. The revision notes below cover some of the main economic and social costs associated with persistent inflation in goods and services.

Effect on UK competitiveness - if the UK has higher inflation than the rest of the world it will lose price competitiveness in international markets. This assumes a given exchange rate. If the exchange rate depreciates, this may help to restore some of the lost competitiveness. Consider the chart above which shows the annual average increase in consumer prices for the UK, the United States and Euroland during the last four decades. Inflation in Britain has been relatively higher than in other major competitor countries - although the chart also indicates a movement towards inflation convergence during the 1990s

This rise in relative inflation leads to a fall in the world share of UK exports and a rise in import penetration. Ultimately, this will lead to a fall in the rate of economic growth and the level of employment.

The problems of a wage-price spiral – price rises can lead to higher wage demands as workers try to maintain their real standard of living. Higher wages over and above any gains in labour productivity causes an increase in unit labour costs. To maintain their profit margins they increase prices. The process could start all over again and inflation may get out of control.

Higher inflation causes an upward spike in inflationary expectations that are then incorporated into wage bargaining. It can take some time for these expectations to be controlled. Higher inflation expectations can cause an outward shift in the Phillips Curve.

Inflation can also cause a reduction in the real value of savings - especially if real interest rates are negative.

This means the rate of interest does not fully compensate for the increase in the general price level. In contrast, borrowers see the real value of their debt diminish. Inflation, therefore, favours borrowers at the expense of savers.

Consumers and businesses on fixed incomes will lose out. Many pensioners are on fixed pensions so inflation reduces the real value of their income year on year. The state pension is normally uprated each year in line with average inflation so that the real value of the pension is not reduced.

However it is unlikely that pensioners have the same spending patterns as those used to create the weights from which the RPI figure is calculated. For example in November 1999, the state pension was up-rated by just 1.1% - the headline rate of inflation for that month.

Inflation usually leads to higher nominal interest rates that should have a deflationary effect on GDP.

Inflation can also cause a disruption of business planning – uncertainty about the future makes planning difficult and this may have an adverse effect on the level of planned capital investment.

Budgeting becomes a problem as firms become unsure about what will happen to their costs. If inflation is high and volatile, firms may demand a higher nominal rate of return on planned investment projects before they will go ahead with the capital spending.

These hurdle rates may cause projects to be cancelled or postponed until economic conditions improve. A low rate of new capital investment clearly damages long-run economic growth and productivity.

Cost-push inflation usually leads to a slower growth of company profits which can then feed through into business investment decisions.

Inflation distorts the operation of the price mechanism and can result in an inefficient allocation of resources. When inflation is volatile, consumers and firms are unlikely to have sufficient information on relative price levels to make informed choices about which products to supply and purchase.

Two further costs of inflation are often mentioned in the textbooks:

Shoe leather costs - when prices are unstable there will be an increase in search times to discover more about prices. Inflation increases the opportunity cost of holding money, so people make more visits to their banks and building societies (wearing out their shoe leather!).

Menu costs - extra costs to firms of changing price information. This can be important for companies who rely on bulky catalogues to send price information to customers. (Note there are also significant menu costs associated with any future transition to the European Single Currency)

Anticipated and unanticipated inflation

When inflation is volatile from year to year, it becomes difficult for individuals and businesses to correctly predict the rate of price inflation that will happen in the near future. When people are able to make accurate predictions of inflation, they can anticipate what is likely to happen and take steps to protect themselves. For example, people can bid for increases in money wages so as to maintain their real wages. Savings can be shifted into accounts offering a higher rate of interest, or into assets where capital gains might outstrip general price inflation. Companies can adjust their prices; lenders can adjust interest rates.

Unanticipated inflation occurs when economic agents (people, businesses and governments) make errors in their inflation forecasts. Actual inflation may end up well below, or significantly above expectations.

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