Consequences of Inflation

Consequences of Inflation

Seen on a large scale high inflation and volatile economists have a range of economic and social costs - hence the importance of continuing attached to the control of inflationary pressures in the economy by the government alike, as well as the central bank (in thecase of the UK, and the Bank of England) . This chapter considerssome of the effects of inflation on the economy.

Why does inflation matter?

The impact of inflation on individuals and businesses depends in part on whether inflation is anticipated or unanticipated:

v Anticipated inflation: 

When people are able to make accurate predictions aboutinflation, they can take the necessary steps to protect themselves from its effects. For example, unions may exercise their collective bargaining power to negotiate with employers to increase wages inmoney and to protect the real wages of union members. Thefamilies also be able to switch savings accounts and depositsprovide the highest nominal rate of interest or other financial assetssuch as stocks or housing in which capital gains over a period of time may exceed general price inflation. In this way, people canhelp to protect the real value of financial wealth. Companies canset prices and lenders can adjust interest rates. Companies mayalso seek to hedge against price fluctuations in the future by thedealers in the "market forward." For example, most major airlinesto buy aviation fuel several months early in the forward market, duein part to protect from fluctuations in world oil prices.

Unanticipated inflation:

When inflation is volatile from year to year, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future. Unanticipated inflation occurs when economic agents (i.e. 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.

Money Illusion

It is a fact of life that people often confuse nominal and real values in their everyday lives because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages – giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income. Money illusion is most likely to occur when inflation is unanticipated, so that people’s expectations of inflation turn out to be some distance from the correct level. When inflation is fully anticipated there is much less risk of money illusion affecting both individual employees and businesses

The Main Costs of Inflation

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 in a speech delivered in 2002 from Mervyn King.

The case for maintaining price stability

‘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 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.’ 

Impact of Inflation on Savers:

Inflation leads to a rise in the general price level so that money loses its value. When 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 Expectations and Wage Demands

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 and higher prices then put further 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.

Arbitrary Re-Distributions of Income

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.

Competitiveness and Unemployment

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 UK government believes that monetary stability (i.e. low inflation) is a precondition for sustained economic expansion.  As the chart below demonstrates, the UK has made progress in reducing the volatility of its inflation rate in the last decade. The era of high and volatile inflation may have come to an end.