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

2. 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

3. 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

4. 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

5. International Inflation Data

6. International Inflation Data

7. 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

8. 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

9. 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.