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Inflation

What danger does inflation pose to any economy? Not an essay title, by the way. Just seeking clarification.

http://www.economicshelp.org/2007/02/costs-of-inflation-in-uk.html

Very easy to Google, if you are looking for more information. There are pros and cons, so make sure you know both if you are a student :smile:

Reply 2

danny111

Uncertainty is a key one.

Reply 3

MagicNMedicine

Make sure you don't make the usual mistake of saying 'inflation erodes peoples earning power and makes them poorer'. This is only true in the short run. The labour market comes into equilibrium as part of a bargaining process between workers and firms. If firms prices are going up, then they need to reflect this in a rise in wages in order to get people to work for them.

Most of the costs of inflation are nuisance costs:
If a firm sets its prices once a year, for the whole year, then by the end of the year the 'real' price is lower than the start of the year (although that of course is good for consumers). If inflation is higher then that means a bigger drop. If it keeps reissuing its prices it means it incurs costs in reprinting documents etc (menu costs)
Same effect happens with tax bands (fiscal drag). Say you buy some shares worth £1000 and then in a years time their value has not changed, but inflation is 10%, then you sell them for £1100. The government will tax you on that £100 you have 'earned' even though the value has not increased, only the nominal price gone up through inflation. Again this is bad for some (individuals) good for others (government), governments are usually slow to increase tax thresholds to take advantage of this.

A bigger issue really is the effect on the market for loans. If you lend somebody £1000 at a nominal interest rate of 8%, and inflation goes to 10% then you are ending up out of pocket, the inflation redistributes money from creditors to debtors. For governments who borrow on the financial markets by issuing bonds, they can 'inflate away' existing debt to a certain extent by letting inflation rise, BUT that will then increase the interest rate they have to offer on new bonds they want to issue, as investors will be wary that inflation might be high in that country. You can solve this problem however by lending/borrowing at rates of interest which are indexed to inflation.

You generally find that economies with high inflation have more variability of inflation (ie one economy might be 2.4% one year, 2.7% the next year, 2.2% the year after, while another is 14% one year, 17% the next year, 10% the next year). The more variability the more people worry about any form of carrying out any form of investment activity in that economy, because investment is always a decision which involves more than one time period (invest now, get your return in the future....when the value of your return depends on the inflation between now and then). As most people and firms are risk averse, they will invest less if they suspect greater inflation variability, so overall economic activity will be higher in lower stable inflation environments than in higher variable ones.

Having said all this, the negatives of inflation only really kick in badly when you start looking at inflation approaching double figures. The difference between 2% inflation and 6% inflation is not going to make major problems for an economy, which is why the Bank of England isn't sweating about inflation in the UK being in the 4.0-5.5% range over the past year or so instead of down at their 2% target, they've still kept interest rates low and are looking at another round of quantitative easing which risks more inflation. Inflation in the range of going up to 6% is useful for a couple of reasons:
- it allows flexibility in the market for wages (classical economists argue that wages need to fall to get out of economic slumps). Usually nobody will accept a nominal wage cut, they go on strike. But if you find that actually wages in the economy or in one industry, are too high to be sustainable, then you can bring them down in real terms if you have inflation. Eg offer a 1% pay rise, with inflation of 5%, means a real terms wage cut of 4%. If inflation is very low then it takes longer to sort out these imbalances in the labour market
- it allows a real negative rate of interest which is sometimes needed when you are trying to stimulate the economy through a monetary expansion in a recession, but if you're an A level student don't worry about this, the explanation relies on ISLM model which is university economics.

One final point to make, which again relies on university level stuff as it is to do with wage bargaining and expectations and the Phillips curve, is that when inflation starts to get higher, it can have a spiralling effect, so where I said before inflation isn't really a problem if you're between 2% and 6%, once you are say around 8% it gets dicey as you can very quickly find that creeps to 12%, 15%, 18% due to aggressive rounds of wage bargaining. It's hard to get high inflation out of the system when workers' expectations of inflation are high, you need to toughen up the bargaining conditions for workers through high rates of unemployment for a number of years. However when you have a 'credible' means of making them think inflation will be low (eg a central bank which targets a low rate, and has a track record of hitting that track rate) then its actually quite easy to keep inflation low, as wage demands tend to be modest, expecting a low rate of price increases, so low inflation becomes a self fulfilling prophecy.

(edited 13 years ago)

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