Why is high inflation a problem?

The countries listed below were experiencing the highest rates of inflation in the world in 2017 according to data from the IMF. Top of the pile was Venezuela which is suffering from hyper-inflation, collapsing output and a steep increase in extreme poverty. The social fabric of the country is deteriorating fast and there is a significant brain drain of people looking for a better life for themselves and their families.

Country (annual rate of inflation in 2017 in percent)

• Venezuela 1,087%
• South Sudan 187%
• Democratic Republic of the Congo 41%
• Sudan 32%
• Angola 29%
• Libya 28%
• Argentina 25%
• Yemen 24%
• Egypt 23%
• Suriname 22%
• Nigeria 16.5%
• Mozambique 15%
• Haiti 14%
• Ukraine 14%
• Azerbaijan 13%
• Uzbekistan 12%
• Ghana 12%

In many countries, the nation’s central bank has been set an inflation target to reach as part of their operation of monetary policy. This is recognition of the economic and social damage that high and volatile inflation can bring.

What are some of the main economic and social costs of high inflation?

Income redistribution:

One risk of higher inflation is that it has a regressive effect on lower-income families and older vulnerable citizens who might be living on a fixed income. If prices are rising faster than wages, then there will be a steep decline in real incomes. Inflation tends to redistribute income and wealth towards groups who are better able to hedge against inflation by sheltering their assets in ways that earn a decent return.

Negative real interest rates:

If interest rates on savings accounts in banks are lower than the rate of inflation, then people who rely on interest from their savings will be poorer. Real interest rates for millions of savers in the UK and many other countries have been negative for at least four years. Hyperinflation destroys the value of savings and means that many families are exposed to high interest-rate debt

Increased cost of borrowing:

High inflation may also lead to higher borrowing costs for businesses and people needing loans and mortgages as financial markets seek to protect themselves against rising prices and increase the cost of borrowing on short and longer-term debt.

Government spending:

High inflation puts pressure on a government to increase the value of the state pension and unemployment benefits and other welfare payments as the cost of living climbs higher.

Inflation expectations and wage demands:

High inflation can lead to an increase in pay claims as people look to protect their real incomes. This can lead to a rise in unit labour costs and lower profits for businesses. However no all workers belong to strong trade unions who can use collective bargaining power to bid for higher pay. A rise in actual inflation can lead to an upward shift in inflation expectations (which can be modelled using Phillips Curve analysis) and once inflation is embedded into an economy, it can be difficult to eliminate.

Business competitiveness in domestic and international markets:

If one country has a much higher rate of inflation than others for a considerable period of time, this will make exports of goods and services less price competitive in global markets. Eventually this may show through in reduced export orders, lower operating profits and fewer jobs, and also in a worsening of a country’s trade balance. A fall in exports can trigger negative multiplier and accelerator effects on real national income and employment.

Business uncertainty and planned investment:

High and volatile inflation is not good for business confidence partly because firms cannot be sure of what their costs and prices are likely to be. This uncertainty might lead to a lower level of capital investment spending which might then damage a country’s productivity growth and long run productive potential.

Social costs of high and volatile inflation:

It puts severe pressure on democratic institutions and can lead to growing political protest and social unrest. Falling real living standards can prompt a brain drain of some a country’s most able and mobile people leaving the country with a diminished labour force. Higher inflation can bring an end to progress in reducing poverty.

Functions of money

Hyperinflation destroys the internal purchasing power of money and undermines its value as a medium of exchange and as a unit of account. Alternative currencies that at least hold some of their value may take the place of the domestic unit of exchange and shadow markets with products traded at unofficial prices often become the norm.