Costs of Inflation

There are many costs associated with inflation; for the economy, 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.

“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%

UK inflation post-warUK inflation post-war. Inflation of the 1970s created instability and led to a decline in the value of savings.

Main costs of inflation

1. Reduced international competitiveness

A relatively higher inflation rate than our trading partners will make British goods less competitive, leading to a fall in UK exports and a deterioration in the UK current account.

  • 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.

2. 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 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.

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 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.

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.

  • However, modern technology has helped to reduce this 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.

  • 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, they will not lose out.

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. 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 rise to 2-4% – it meant workers saw a fall in real wages

wages-inflation

Graph sowing Inflation higher than wage growth 2010-2015

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 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.

Hyperinflation costs

hyperinflation

In periods of extreme inflation (e.g. inflation rates over 100%) 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. 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 wheelbarrow stolen!

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

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