Q&A - Outline the main costs and benefits of inflation

Inflation has many important costs and consequences for both society and business. However a stable and low level of inflation also provides some upsides for business.

Inflation has many costs and downsides, including:

• Money loses its value and people lose confidence in money as the value of their savings is reduced
• Inflation can get out of control - price increases lead to higher wage demands as people try to maintain their living standards. This is known as a wage-price spiral.
• Consumers and businesses on fixed incomes lose out because the their real incomes fall - employees in poor bargaining positions also lose out
• Inflation can favour borrowers at the expense of savers – because inflation erodes the real value of existing debts
• Inflation can disrupt business planning and lead to lower capital investment
• Inflation is a possible cause of higher unemployment in the long term – because of a lack of competitiveness
• Rising inflation is associated with higher interest rates - this reduces economic growth

By contast, some inflation can acutally be good news. With a sensible, low level of general price inflation:

• Industry-wide price rises enable revenues to grow
• Growing revenues + a constant gross margin = higher gross profits
• Inflation makes using debt as a source of finance cheaper in real terms

The two key issues to consider in relation to the adverse effects of inflation are:
- Price elasticity of demand
- Responding to cost-push inflation

You will recall that price elasticity refers to the responsiveness of demand to changes in price

• When demand is elastic, a price rise leads to a more than proportionate fall off in quantity demanded
• When demand is inelastic, a price rise leads to a less than proportionate fall off in quantity demanded

Firms with inelastic price elasticity of demand will be less affected by a rise in inflation

Some firms will be able to absorb price increases by becoming more efficient. But remember that price inflation will vary from industry to industry – be careful about making generalisations!

Thinking about the effect of rising costs on a business: with a rise in general inflation:

• Sales revenue should rise
• But workers likely to demand higher pay to compensate for consumer price inflation
• Labour intensive industries more at risk
• Cost-push inflation will vary from industry to industry
• Firms that need to buy significant commodity raw materials may find profit margins squeezed if they cannot pass on increased costs to customers