Author: Geoff Riley Last updated: Sunday 23 September, 2012
Analysing the Consequences of Inflation
High and volatile inflation has economic and social costs.
When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects.
Trade unions might use their bargaining power to negotiate for increases in money wages to protect the real wages of union members.
Households may switch savings into accounts offering a higher rate of interest or into other financial assets where capital gains might outstrip price inflation.
Businesses can adjust prices and lenders can adjust interest rates. Businesses may also seek to hedge against future price movements by transacting in “forward markets”. For example, many airlines buy their fuel months in advance as a protection or ‘hedge’ against fluctuations in world oil prices.
When inflation is volatile, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future.
Unanticipated inflation occurs when people, businesses and governments make errors in their inflation forecasts. Actual inflation may end up below or above expectations causing losses in real incomes and a redistribution of income and wealth from one group to another
People often confuse nominal and real values 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.
The Economic Costs of Inflation
We must be careful to distinguish between different degrees of inflation, since low and stable inflation is less damaging than hyperinflation where prices are out of control.
Impact of Inflation on Savers: When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if interest rates are lower than inflation – leading to negative real interest rates. This has certainly happened in the UK during 2009-2011.
Inflation Expectations and Wage Demands: Price increases lead to higher wage demands as people try to maintain their real living standards. This process is known as a ‘wage-price spiral’.
Arbitrary Re-Distributions of Income: Inflation tends to hurt people 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.
Business Planning and Investment: Inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs - and this may reduce planned investment spending.
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.
Benefits of inflation
Can inflation have positive consequences? The answer is yes although much depends on what else is happening in the economy. Some of the potential advantages of benign inflation are as follows:
Higher revenues and profits: A low stable rate of inflation of say between 1% and 3% allows businesses to raise their prices, revenues and profits, whilst at the same time workers can expect to see an increase in their pay packers. This can give psychological boost and might lead to rising investment and productivity.
Tax revenues: The government gains from inflation through what is called ‘fiscal drag effects’. For example many indirect taxes are ad valorem in nature, e.g. VAT at 20% - so as prices rise, so does the amount of tax revenue flowing into the Treasury.
Cutting the real value of debt: Low stable inflation is also a way of helping to reduce the real value of outstanding debts – there are many home owners with huge mortgages who might benefit from a period of inflation to bring down the real burden of their mortgage loans. The government too might welcome a period of higher inflation given the huge level of public sector debt!
Avoiding deflation: Perhaps one of the key benefits of positive inflation is that an economy can manage to avoid some of the dangers of a deflationary recession (discussed in the next chapter)