Is Inflation Harmful?

Q. Should the Government be concerned if the CPI rises to 5% ?

Costs of Inflation

The Govt set the MPC a target for CPI of 2.% +/-1. It believes inflation higher than 3.0% is potentially damaging for the economy.

  1. It depends on inflation in other countries. If inflation in the UK is higher than elsewhere, then UK goods will become uncompetitive leading to a fall in demand for UK exports.If there is a fall in demand for Exports then there may be a deficit on the current account Balance of Payments. However this may be offset by a devaluation that is likely to occur
  1. If inflation is high there will be a devaluation of the exchange rate, This is something the govt wishes to avoid as it creates uncertainty amongst business and lower purchasing power of Sterling abroad.
  1. Higher rates of inflation may cause menu costs, which means firms have to change price lists quite often. However, this is not that significant when inflation is only 5%.
  1. If inflation is caused by unsustainable economic growth then the boom may be followed by a recession . To reduce inflation and keep inflation withinthe target, the B of E will have to increase interest rates; this causes problems because AD will fall causing lower growth.
  1. Higher rates of inflation are disliked by business because it makes it more difficult to predict future costs. Therefore investment will be lower. Countries with lower inflation rates generally have poorer economic growth.
  1. A high rate of inflation would make it more difficult to join the EURO, because it would breach the Maastricht criteria. If inflation in the UK was higher than Europe a single Monetary policy would be ineffective for the UK.
  1. If the inflation was world wide caused by an increase in the oil price, it may be necessary to revise the inflation target of 2.% . The UK would not lose its competitive advantage because every country would have higher inflation. To reduce inflation could cause stagflation (lower growth and higher prices)
  1. Inflation may cause redistribution of income from savers to borrowers. This is because inflation reduces the value of money. However, this will depend upon the rate of interest. E.g. if interest rate were 8% and inflation 5%, savers would still have a real interest rate of 3%
  2. It depends on whether wages are keeping up with inflation. If wages were only increasing by 4% then real wages would be falling.

Costs of Low Inflation / Deflation

 

Should the govt be concerned with inflation falling below 2.0%?

  1. If prices are falling because AS shifts to the right because of new technology, this is beneficial for the economy, because growth is increasing and jobs should be being created.
  1. If deflation is cause by falling AD then this is serious economic problem because it indicates a recession with problems such as unemployment, lower output and a negative multiplier effect.
  1. Deflation can cause problems for the economy. It means that those who have debts will see the real value of debts increase, this will lead to lower consumer confidence and possibly lower AD and economic growth.
  1. Deflation makes monetary policy ineffective. This is because interest rates cannot be reduced below 0%.
  1. Companies cannot alter real wages easily because workers are very resistant to any cut in nominal wage wages. Therefore, real wages may rise.
  1. It is more difficult to set prices when there is deflation