Inflation - The Details

Inflation - The Details

This was covered in a general way in the topic called 'Macroeconomic objectives'. The costs of inflation were discussed in terms of why inflation is a 'bad' thing. The 'shoe-leather' and 'menu' costs were described as less important. These also happen to be the only costs of anticipated inflation. All of the more serious costs arise as a result of unanticipated inflation. These include the redistribution effects, lack of investment, and lack of growth. Let's look at these in more detail.

  1. 'Shoe-leather' costs. This refers to the time wasted (and worn shoe leather!) searching the market place for the lowest price. This is much harder when inflation is high. High inflation tends to coincide with variable inflation and, therefore, very unstable prices.
  2. 'Menu' costs. This refers to the costs of inflation to businesses in terms of continually having to change their menus, price tags, vending machines, etc. due to the continually changing price.
  3. Redistribution effects. Periods of high inflation cause a redistribution from savers to borrowers. Inflation erodes the real value of all money. Hence, if you are a net saver, the real value of your savings will fall, which is bad for the saver, but if you are a net debtor, the real value of what you owe will fall, which is good for the borrower. The interest rate that is earned on one's saving will usually be higher than the inflation rate, but there have been times when the rate of interest does not keep up with the inflation rate, and so savers are paid a negative real interest rate. The best example of debtors gaining from inflation is the housing market. Most of your parents will have 'made' money on their house. Of course, they do not 'realise' (i.e. get their hands on) this gain in wealth whilst they live in the property, but their mortgage remains relatively constant (especially if they are on a fixed rate mortgage) as their earnings rise over the years. Also, they can borrow against the increased value of the property to buy a car, go on holiday or extend the house. Economists do not like this redistribution from savers to borrowers. It penalises thrift, which is a bad thing for the economy because, over the long term, the amount of investment in an economy is closely related to the amount of saving.
  4. The lack of investment. Unanticipated inflation causes uncertainty. Firms hate uncertainty. They want to be able to plan ahead, and unpredictable inflation makes this difficult. The amount of money that firms invest in new machinery is likely to be lower in times of high inflation because it is difficult for the firms to be confident that the investment will be worthwhile. Lower investment means lower aggregate demand and a lower future productive potential. Keynesian economists don't like the former and monetarists don't like the latter.
  5. The lack of growth. This follows on from the last point. Lower investment will lead to lower growth in GDP. Also, at times of high inflation, the Monetary Policy Committee are likely to raise interest rates in an effort to deflate the economy and reduce the inflation rate. Higher interest rates will result in firms investing less, consumers spending less (due to higher mortgage payments and the cost of borrowing to buy 'big ticket' items) and the value of the £ rising, which is bad for exporters. Exporters also lose out because their goods will be less competitive abroad, even for a given exchange rate (a double whammy!). Again, all of these things point to a lower rate of growth in the economy.

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