There are many costs associated with inflation; 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, a fall in real wages 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.
“Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
– John Maynard Keynes, (1919) “The Economic Consequences of the Peace” Chapter VI, pp. 235-236.
Most countries target low inflation, usually around an inflation rate of 2%
Explaining the costs of inflation
1. 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 2010-14, 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 showing Inflation higher than wage growth 2010-2015. Also, between 2021 and 2023 inflation was higher than wage growth, causing a fall in real incomes.
Note: Inflation doesn’t always mean real wages will fall, it used to be quite rare, but in interviews, non-economists see this has biggest cost of inflation. (see: Why we hate inflation)
2. 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
- However, if a country is in a floating exchange rate – then the high inflation can be offset by a depreciation in the currency. Though this still has an economic cost as it is a decline in the terms of trade and more expensive imports.
3. Confusion and uncertainty (less investment)
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 investment and 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. For example
The UK’s relative decline compared to Japan, Germany and France was at least partly attributed to higher inflation in the 1970s.
4. 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
5. Menu costs
This is the cost of changing price lists. When inflation is high, prices need frequently changing which incurs a cost. However, modern technology has helped to reduce this cost to some extent.
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.
- However, it does depend on the real rate of interest. e.g. if a saver gets a higher rate of interest than the inflation rate, they will not lose out. This occurred in the period from 2007to 2008. However, from 2008 to 2025, the inflation rate is nearly always higher than interest rates – and so savers were losing out in this period.
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. 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. (without higher bond yields)
UK inflation post-war. Inflation of the 1970s created instability and led to a decline in the value of savings.
10. Higher bond yields/debt interest payments
The rise in the cost of debt interest payments was closely linked to a jump in UK inflation. Some bonds were index-linked (meaning interest payments depended on inflation). But, also higher inflation leads to higher bond yields.
In 2022-25, the UK had higher inflation than other countries and this led to bond yields rising. This made it more expensive for the UK to pay debt interest payments.
11. Shoe leather costs
To save on losing interest in a bank people will hold less cash and make more trips to the bank.
Costs of Hyperinflation
- Decline confidence In periods of extreme inflation (e.g. inflation rates over 500%) inflation undermines basic economic confidence and can destroy usual economic activity. With periods of hyperinflation, people lose all confidence in money and try to spend as soon as they receive it.
- Barter economy. In countries with hyperinflation, we often see a ‘barter economy’ emerge with consumers exchanging goods for services – as money becomes worthless. The diagram above is from Germany in 1923 when hyperinflation made money worthless. There are stories of people using a wheelbarrow to carry around money. When they stopped outside a shop, the money was left but the wheelbarrow stolen!
- Inconvenience During hyperinflation, the cost of dealing with rising prices can become extreme. With prices rising by up to 100% a day – as soon as people get paid, they have to go out and spend it. In some cases, workers needed paying twice a day.
- Redistribution. During hyperinflation, there is also a very rapid redistribution of income – because interest rates cannot keep up with the rising prices. It tends to hit the middle-class savers the most. The only sections of society insulated from hyperinflation are those who own physical assets or debtors who see the real value of debts wiped out.
- Currency collapse
In the Germany hyperinflation, the German mark collapsed in value, meaning that it became very difficult for Germans to buy imports.
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.
- Low inflation is often seen as harmless or even beneficial because it allows prices to adjust more easily
Why People Hate Inflation
In 2024, President Biden was standing for re-election. Despite the inflation rate falling, the cost of living was a major problem. From an economic point of view, economists pointed out wages increased faster than inflation, but it was not convincing.
What happened is workers remember the period where inflation was rising faster than wages
1. Price level vs Inflation. Workers have seen an increase in the price level, in the past three years
By 2025, UK inflation rate is down, but prices are still 27% higher than in 2021. The point is that if you go shopping, you still feel that 27% rise in cost of living.
2. Blame. Psychologically, people blame inflation on the failure of the government. But, see rise in wages as due to their effort. So even rising wages and inflation, people dislike more than low inflation and low wage rise.
More on why people hate inflation
Further reading