Low inflation is the main macro economic goal for most developed economies. This is because there are many economic costs of high inflation.
Costs of inflation include:
- Reduced international competitiveness
A relatively higher inflation rate will make British goods less competitive, leading to a fall in exports. However this may be offset by a decline in the exchange rate. But, if a country is in the Euro (e.g. Greece, Ireland and Spain) they can’t devalue. Therefore, high inflation can be very damaging as it leads to a decline in competitiveness.
- Confusion and uncertainty
When inflation is high people are uncertain what to spend their money on. Also, when inflation is high firms may be less willing to invest because they are uncertain about future 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.
- 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 economic growth. E.g. in the UK, low inflation helped economic growth to be more stable in the period 1992-2007. Sustainable, low inflationary, economic growth is highly desirable.
Boom and bust in the late 1980s.
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
- Menu costs
This is the cost of changing price lists. When inflation is high, prices need changing frequently which incurs a cost. However, modern technology has helped to reduce this cost.
- Shoe leather costs
To save on losing interest in a bank people will hold less cash and make more trips to the bank.
- Income redistribution
Inflation will typically make borrowers better off and lenders worse off. Inflation reduces the value of savings, especially if the saving is not index linked. However it does depends on the real rate of interest. e.g. if a saver gets a higher rate of interest than the inflation rate he will not lose out.
- 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 will lead to a decline in economic growth and unemployment. Therefore, it is better to keep inflation low and avoid later more costly efforts to reduce it.
- Fiscal drag
The amount of tax we pay will increase if there is inflation. This is because with rising wages more people will slip into the top income tax brackets. See: Fiscal Drag
- low inflation is often seen as harmless or even beneficial because it allows prices to adjust more easily
Anticipated and unanticipated inflation
If inflation is unanticipated (e.g. people expect a lower inflation rate) then the costs will be more serious than if the inflation rate was expected. It is unanticipated inflation that can negatively impact on a firm’s costs.