There are many costs associated with inflation; the volatility and uncertainty can lead to lower levels of investment and lower economic growth. For individuals, inflation can lead to a fall in the value of their savings and redistribute income in society from savers to lenders and those with assets. At extreme levels, inflation can destabilise society and destroy confidence in the economic system. Show
Most countries target low inflation – usually around an inflation rate of 2% Explaining the costs of inflation1. Reduced international competitiveness If a country has a relatively higher inflation rate than its trading partners, then its exports will become less competitive, leading to a fall in exports and a deterioration in the UK current account. This is particularly a problem for a country in a fixed exchange rate. For example, countries in the Euro, such as Greece, Ireland and Spain experienced higher inflation than northern Eurozone, leading to record current account deficits (over 10% of GDP in 2007. The uncompetitiveness also caused a fall in economic growth
2. Confusion and uncertainty When inflation is high, people are more uncertain about what to spend their money on. Also, when inflation is high, firms are usually less willing to invest – because they are uncertain about future prices, profits and costs. This uncertainty and confusion can lead to lower rates of economic growth over the long term. This is one of the main concerns about high inflation rates. Countries with low and stable inflation rates – tend to have improved economic performance over countries with higher inflation. 3. Boom and bust economic cycles High inflationary growth is unsustainable and is usually followed by a recession. By keeping inflation low, it enables a long period of sustainable economic growth. For example, in the UK in the period 1992-2007, low inflation helped economic growth to be more stable – than the previous boom and bust cycles. In the late 1980s, the UK enjoyed rapid economic growth. However, this led to a rise in inflation. This inflationary growth proved unsustainable, and in 1991 the economy entered a deep recession with negative economic growth. See: Lawson Boom 4. Menu costs This is the cost of changing price lists. When inflation is high, prices need frequently changing which incurs a cost.
5. Shoe leather costs To save on losing interest in a bank people will hold less cash and make more trips to the bank. 6. Income redistribution Inflation will typically make borrowers better off and lenders worse off. Inflation reduces the value of savings, especially if the savings are in the form of cash or bank account with a very low-interest rate. Inflation tends to hit older people more. Often retired people rely on the interest from savings. High inflation can reduce the real value of their saving and real incomes.
7. Cost of reducing inflation High inflation is deemed unacceptable therefore governments / Central Bank feel it is best to reduce it. This will involve higher interest rates to reduce spending and investment. This reduction in Aggregate Demand (AD) will lead to a decline in economic growth and unemployment. Inflation is reduced, but there is a cost to other macro-economic objectives. Therefore, it is better to keep inflation low and avoid later more costly efforts to reduce it. 8. Fiscal drag The amount of tax we pay increases if there is inflation. This is because with rising wages more people will slip into the top income tax brackets. See: Fiscal Drag 9. Falling real incomes In periods of nominal wage restraint, even a small increase in inflation can lead to a fall in real wages. For example, in the period 2010-17, the UK experience pay restraint – especially amongst public sector workers, with wages limited by 1% a year. However, with inflation at 2-4% – it meant workers saw a fall in real wages
Graph sowing Inflation higher than wage growth 2010-2015 (falling real wages) 10. Bondholders lose out In the 1970s, many investors expected low inflation. Therefore they bought government bonds with interest rates of around 6%. With low inflation of 3-4%, they gain from buying government bonds. However, in the 1970s, inflation was much higher than expected and higher than the nominal interest rate. Therefore, bondholders saw a fall in the real value of their bonds. This made it easier for the government to pay back their debt, but it means investors lose out. Also, it makes investors less willing to purchase government bonds in the future.
UK inflation post-war. Inflation of the 1970s created instability and led to a decline in the value of savings. Hyperinflation costs
Further reading
What are considered to be the 4 costs of inflation?Inflation is a highly controversial topic because many people consider it to be a severe economic problem. There are five costs of inflation: shoeleather costs, menu costs, relative price variability, tax distortions, and confusion, and inconvenience.
What are the costs of inflation?In this economy, inflation can impose only two real costs: the less efficient arrangement of transactions that result from holding smaller money balances and the necessity to change posted prices more frequently (the so-called menu costs).
What are the 4 main causes of inflation?Here are the major causes of inflation:. Demand-pull inflation. Demand-pull inflation happens when the demand for certain goods and services is greater than the economy's ability to meet those demands. ... . Cost-push inflation. ... . Increased money supply. ... . Devaluation. ... . Rising wages. ... . Policies and regulations.. What are the 4 consequences of inflation?Inflation raises prices, lowering your purchasing power. Inflation also lowers the values of pensions, savings, and Treasury notes. Assets such as real estate and collectibles usually keep up with inflation. Variable interest rates on loans increase during inflation.
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