Effects of A Falling Inflation Rate

Readers Question: Evaluate the possible consequences of a falling rate of inflation for the performance of the UK economy.

A falling rate of inflation means that prices will be rising at a slower rates.

It depends on why the inflation rate is falling. If inflation falls from 2.5% to 1.5% as a result of falling aggregate demand, then the UK will experience lower economic growth and possibly recession. This will be harmful and lead to higher levels of unemployment.

If the rate of inflation keeps falling the UK may experience deflation, this will cause further problem, when prices fall people are reluctant to spend because goods will be cheaper in the future. Therefore, there is even slower growth (like Japan).

However, if inflation falls because of increased productivity and better technology. This means that the AS curve will shift to the right. It means that the UK will benefit from both lower inflation and higher growth. For example, new computer technology means prices are falling and we benefit from better equipment.

If inflation does fall then there will be other benefits from having a low inflation rate such as:

• More competitive exports (UK goods rise less than other countries)
• More certainty and and less confusion encouraging investment
• Lower menu costs (though quite insignificant at the moment)

For more detail see: Costs of Inflation

basically these costs will be avoided.

Generally MPC try to avoid inflation. But, note they have a target of 2%. Therefore if inflation falls to 0.5% then that is not good because of the lower growth effect.