Costs and Benefits of Inflation A2 Economics revision presentation on the economic consequences of inflation

The Economic Costs of Inflation The economic costs of inflation depend on (i) The degree of inflation More costly when inflation is high and variable E.g. UK economy from the mid 1970s – to the early 1990s (ii) Whether inflation is Correctly anticipated by consumers and producers Unanticipated – I.e expectations of inflation turn out to be wrong (iii) Whether inflation in one country is higher than in other countries with whom trade takes place (iv) Whether the nominal exchange rate adjusts to restore lost price and cost competitiveness for exporters

The Main Economic Costs of Inflation (1) Inflation causes a re-distribution of income and wealth From lenders to debtors if real interest rates become negative Away from those on fixed incomes or with weak bargaining power From tax-payers to the government because of fiscal drag effects (2) Loss of international competitiveness “Expenditure-switching effects” away from UK exports overseas Imports become relatively cheaper (rising import penetration) (3) Monetary policy response to high inflation Higher nominal interest rates – negative effect on output, investment (4) Loss of business confidence (lower planned investment) due to uncertainty and lower expected real rates of return on capital (5) Increased inflation expectations (6) Micro costs of inflation Shoe-leather and menu costs

Bank of England on the Costs of Inflation Uncertainty about the value of money - the future prices of goods and services - can be damaging to the proper functioning of the economy Price stability is important because high and volatile inflation creates economic instability Monetary policy is aimed at achieving price stability. But the goal of price stability is not an end in itself Stable prices are a necessary condition for the economy to grow in a stable and sustainable way, and for the effective functioning of prices and money in the economy

International Inflation Data

International Inflation Data

What is Price Stability? Alan Greenspan’s definition of price stability “We will be at price stability when households and businesses need not factor expectations of changes in the average level of prices into their decisions” “Price stability" implies that business and household decision-making should be able to proceed on the basis that "real" and "nominal" values are substantially the same over the planning horizon No hard and fast numerical rule for price stability – but steady inflation of 1-3% must come close to meeting the requirements

The Benefits of Low Inflation “Overall, it is clear that there are many benefits from the successful achievement of low and stable inflation, especially in terms of greater macroeconomic stability and improved efficiency.” “In addition, firms and households are able to plan with greater confidence, and there are efficiency gains from the greater transparency of relative prices” Kate Barker Member of the Monetary Policy Committee Speech to the Manchester Statistical Society, February 2003

Possible Developments from Switch to Low Inflation Country The risk of a general deflation The impact on manufacturing of prolonged deflation in that sector A restricted ability of relative wages to adjust, to the extent that zero represents a lower bound on pay settlements Lower profitability, as lower inflation improves price transparency and increases competitive pressures The decline in annuity rates and in investment returns putting downward pressure on pensions A lower household savings rate as low nominal interest rates are seen as unattractive Willingness to take on higher levels of household debt, fostering inter- alia sharp rises in house prices.