tutor2u™ - Inflation Essentials
Inflation is widely seen to have a range of economic and social costs. The impact of inflation on individuals and businesses depends in part on whether inflation is anticipated or unanticipated:
Anticipated inflation: When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects. For example, trade unions may exercise their collective bargaining power to negotiate with employers for increases in money wages so as to protect the real wages of union members. Households may be able to switch their savings into deposit accounts offering a higher nominal rate of interest or into other financial assets such as housing or equities where capital gains over a period of time might outstrip general price inflation. In this way, people can help to protect the real value of their financial wealth. Companies can adjust prices and lenders can adjust interest rates.
Unanticipated inflation: When inflation is volatile from year to year, it is difficult for individuals and businesses to correctly predict the rate of inflation in the near future. 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 causing losses in real incomes and a redistribution of income and wealth from one group in society to another.
What are the main costs of inflation? Why is the control of inflation given such a high priority in macroeconomic policy-making? Supporters of tough inflation control would support the arguments made in this quote from Meryvn King, the Governor of the Bank of England.
‘Taken together, the verdict of economics, history and common sense is that inflation and deflation are costly. It is clear that very high inflation – in extreme cases hyperinflation – can lead to a breakdown of the economy. There is now a considerable body of empirical evidence that inflation and output growth are negatively correlated in high-inflation countries. For inflation rates in single figures, the impact of inflation on growth is less clear.’
Mervyn King adapted from a speech entitled “The Inflation Target – Ten Years On” given in 2002. The full speech is available from the BoE web site
In explaining and assessing the costs of inflation, we must be careful to distinguish between different degrees of inflation, since low and stable inflation is widely perceived to have less of a damaging effect on the macro-economy than hyperinflation where prices are out of control. Another important part of your evaluation is to be aware that inflation will have differing effects both on individuals and also the performance of the economy as a whole.
Inflation leads to a rise in the general price level so that money loses its value. When the rate of inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if nominal interest rates are lower than inflation – leading to negative real interest rates. For example a saver might receive a 3% nominal rate of interest on his/her deposit account, but if the annual rate of inflation is 5%, then the real rate of interest on savings is -2%.
Inflation can get out of control because price increases lead to higher wage demands as people try to maintain their real living standards. Businesses then increase prices to maintain profits. Higher prices then put further upward pressure on wages. This process is known as a ‘wage-price spiral’. Rising inflation leads to a build-up of inflation expectations that can worsen the trade-off between unemployment and inflation.
Inflation tends to hurt those employees in jobs with poor bargaining positions in the labour market - for example people in low paid jobs with little or no trade union protection may see the real value of their pay fall. Inflation can also favour borrowers at the expense of savers as inflation erodes the real value of existing debts. And, the rate of interest on loans may not cover the rate of inflation. When the real rate of interest is negative, savers lose out at the expense of borrowers.
More generally, inflation can disrupt business planning. Budgeting becomes difficult and this may reduce planned capital investment spending. Lower investment then has a detrimental effect on the economy’s long run growth potential (i.e. it limits the growth of a country’s long run aggregate supply)
Inflation is a possible cause of higher unemployment in the medium term - if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance. If inflation in the UK is persistently above our major trading partners, British exporters may struggle to maintain their share in overseas markets and import penetration into the UK domestic market will grow. Both trends could lead to a worsening balance of payments. The Government believes that monetary stability (i.e. low inflation) is a precondition for sustained economic expansion.
Rising inflation is associated with higher nominal interest rates because the Bank of England seeks to control inflationary pressure by raising the level of base interest rates – this reduces economic growth and can lead either to a slowdown or a recession.
The chart above tracks nominal interest rates and underlying inflation (RPIX) from 1988-2003. Interest rates doubled from 7.5% to 15.0% over the period June 1988 – September 1989 in order to curb the inflationary excesses of the Lawson ‘consumer boom’ and interest rates stayed at 15% for a full calendar year thereafter causing the economy to tip into a deep recession in 1990-92.
Although interest rates came down gradually during our short-lived membership of the semi-fixed exchange rate system, they had to be kept artificially high because of the UK’s commitments inside the European Exchange Rate Mechanism. The effect was to deepen the recession and cause a severe slump in the UKousing market and a rise in unemployment towards a level of three million people out of work.
Following sterling’s departure from the ERM in the autumn of 1992, interest rates fell sharply to 6.0% by the spring of 1993 and in the decade since they have remained within a fairly narrow range of 3.5% to 7.5%. RPIX inflation has been remarkably stable over the last ten years, which has reduced the need for large changes in interest rates as an instrument to control wage and price inflation.