widespread agreement that high and volatile inflation can be damaging both to
individual businesses and consumers and also to the economy as a whole.
economists disagree about the relative seriousness of inflation. The revision
notes below cover some of the main economic and social costs associated with
persistent inflation in goods and services.
UK competitiveness - if the UK has higher inflation than the rest of the
world it will lose price competitiveness in international markets. This
assumes a given exchange rate. If the exchange rate depreciates, this may
help to restore some of the lost competitiveness. Consider the chart above
which shows the annual average increase in consumer prices for the UK, the
United States and Euroland during the last four decades. Inflation in Britain
has been relatively higher than in other major competitor countries -
although the chart also indicates a movement towards inflation convergence
during the 1990s
in relative inflation leads to a fall in the world share of UK exports and a
rise in import penetration. Ultimately, this will lead to a fall in the rate
of economic growth and the level of employment.
problems of a wage-price spiral – price rises can lead to higher wage
demands as workers try to maintain their real standard of living. Higher
wages over and above any gains in labour productivity causes an increase in
unit labour costs. To maintain their profit margins they increase prices. The
process could start all over again and inflation may get out of control.
inflation causes an upward spike in inflationary expectations that are then
incorporated into wage bargaining. It can take some time for these
expectations to be controlled. Higher inflation expectations can cause an
outward shift in the Philips Curve. Inflation
can also cause a reduction in the real value of savings - especially if real
interest rates are negative.
the rate of interest does not fully compensate for the increase in the
general price level. In contrast, borrowers see the real value of their debt
diminish. Inflation, therefore, favours borrowers at the expense of savers.
and businesses on fixed incomes will lose out. Many pensioners are on fixed
pensions so inflation reduces the real value of their income year on year.
The state pension is normally uprated each year in line with average
inflation so that the real value of the pension is not reduced.
is unlikely that pensioners have the same spending patterns as those used to
create the weights from which the RPI figure is calculated. For example in
November 1999, the state pension was up-rated by just 1.1% - the headline
rate of inflation for that month.
usually leads to higher nominal interest rates that should have a
deflationary effect on GDP.
can also cause a disruption of business planning – uncertainty about the
future makes planning difficult and this may have an adverse effect on the
level of planned capital investment.
becomes a problem as firms become unsure about what will happen to their
costs. If inflation is high and volatile, firms may demand a higher nominal
rate of return on planned investment projects before they will go ahead with
the capital spending. These
hurdle rates may cause projects to be cancelled or postponed until economic
conditions improve. A low rate of new capital investment clearly damages
long-run economic growth and productivity.
inflation usually leads to a slower growth of company profits which can then
feed through into business investment decisions.
distorts the operation of the price mechanism and can result in an
inefficient allocation of resources. When inflation is volatile, consumers
and firms are unlikely to have sufficient information on relative price
levels to make informed choices about which products to supply and purchase.
leather costs - when prices are unstable there will be an increase in search
times to discover more about prices. Inflation increases the opportunity cost
of holding money, so people make more visits to their banks and building
societies (wearing out their shoe leather!).
- extra costs to firms of changing price information. This can be important
for companies who rely on bulky catalogues to send price information to
customers. (Note there are also significant menu costs associated with any
future transition to the European Single Currency)
and unanticipated inflation
the costs of inflation to consumers are smaller when inflation is
anticipated. They can take steps to protect the real value of their income
and savings. The economic problems from high and variable inflation are more
serious for the whole economy in the long run - particularly for those
countries that are heavily dependent on international trade for their