Importance of Inflation For Industry

CPI % Change

The inflation rate is a key statistic. High rates of inflation often discourage investment and lead to lower long term growth for the following reasons:

• High and volatile inflation creates uncertainty and confusion about future prices and costs, this tends to reduce investment and lead to lower rates of growth in the economy. Therefore less demand for goods.
• Menu costs of changing price lists. When inflation is high, prices need to be changed more frequently, which incurs a cost. Also high rates of inflation may incur frequent wage negotiations with trades unions who will be trying to maintain their real wages; this can be costly for a manufacturing firm.
• High inflationary growth is often unsustainable. To reduce inflation often requires painful readjustment such as higher interest rates and deflationary fiscal policy; these lead to lower growth. Therefore countries with high inflation may be susceptible to a recession in the near future.
• Less competitive. High inflation means costs will be rising and this will make the country’s exports less competitive compared to the rest of the world.
• Less Confidence. People are suspicious of country’s with high rates of inflation, it discourages inward investment and creates lower growth.

• Note inflation is considered to be a serious problem at over 10%. Anything over 100% could lead to hyper inflation and serious destabilisation.
• Inflation between 2-4% would be considered a good target

Deflation

Deflation is when prices fall. In many cases this can be worse than inflation. Falling prices discourage people from spending and leads to lower growth, for example, Japan in the late 1990s. (Ocassionally deflation may occur due to technological improvements.

CPI trend

The previous trend of inflation is instructive because inflation rates are often influenced by past inflation rates. i.e if inflation trends have been high in the past it encourages people to demand higher wages and pass cost increases on. Therefore, Inflation expectations become self fulfilling. A country with a low inflation trend makes an attractive proposition for investment because it suggests economic stability, economic maturity and less risk associated with the investment.

Countries with persistently low inflation, make an attractive place for investment because they offer economic stability which encourages firms and investors.

See also:

• Costs of Inflation