The costs of inflation

The costs of inflation

Price inflation is a macro-economic problem because it can adversely affect the real economy.

Inflation is defined as a general rise in the average level of prices, and a fall in the purchasing power of money. This does not mean that all prices are rising - only that the average level is rising.

Inflation can cause a range of economic problems - however, the extent of the problem depends upon whether inflation is anticipated or not, how extreme it is, and how extended it is over a period of time.

If inflation is anticipated then individuals, households and firms can build the expectation of inflation into their own behaviour, and to some extent offset any impact on their own finances and assets. For example, if annual inflation typically tracks at around 2%, then wage negotiations can build-in a 2% pay rise simply to maintain the same real pay. Price setting by firms, and tax rates and tax allowances by governments can also take expected inflation into account. However, if the price level behaves more erratically it will be less easy to predict and harder to build-in actions and behaviour that offset inflation.

Inflation erodes the value of money

Increases in the average level of prices will result in a fall in the purchasing power of a fixed 'nominal' quantity of money. Unless households can increase their holding of nominal money, they will experience a decline in the real (purchasing power) value of money.

For example, take an individual who purchases 100 units of a good at a specific unit of currency - say $1 (or equivalent). They have a current nominal income of $100 (or equivalent). Their real income and nominal money income are the same [$100]. Now, if over a year, prices inflate by 5%, making the good's price rise to $1.05 per unit, the same fixed nominal income of $100 can only purchase 95.24 units (which we could round down to 95.). This may not appear a significant number, but with an inflation rate of 5%, it would not take very long for the value of money to erode by a significant amount [in fact, at a steady 5% compound reduction, by year 10 the real value would have fallen by approximately 40% (39%)].

It is clear, then, that inflation will only reduce living standards if specific criteria are met - namely, that nominal incomes do not rise at the same rate as inflation. If prices and income rise at the same rate, then on average, people are no worse off!

Erodes the value of savings and investments

In exactly the same way, the value of any savings will fall, putting pressure on those that rely on savings in later life, or who use savings to make a future purchase. The value of investments in securities such as shares and bonds will also be eroded as a result of inflation. The value of future returns will fall as inflation erodes the value of these returns. Investing in stocks and property is likely to be more attractive at times of inflation than investing in cash or debt securities (treasury bills and bonds) given that they are likely to be 'inflation protected'.

Redistribution of real income

Individuals and firms that can protect themselves from the effects of inflation may fair better than those that cannot, with the consequence that real income drifts from the 'unprotected sector' to the 'protected' one. For example, individuals with property assets tend to be protected from inflation as the prices of these assets tend to appreciate by at least the rate of inflation. In contrast, individuals on fixed incomes or with no assets will suffer a considerable 'inflation burden'. Borrowers will also tend to do well relative to lenders as the 'real' value of repayments falls over time. This is one reason why lenders readjust interest rates upwards to compensate for the inflationary effect on the value of repayments.

Interest rate increases

A rise in the price level is likely to lead to an increase in interest rates. Firstly, lenders will need to increase rates to reflect the falling value of repayments in the future, Secondly, central banks may increase their base rates as a way of dealing with inflationary pressure, especially coming from the demand-side of the economy. However, there may be unintended consequences of such tighter monetary policy. While increasing interest rates may dampen household demand and reduce inflationary pressure the same interest rate rises will impact on investment by firms. Falling investment may itself lead to several other negative consequences, including job losses, lower labour productivity, and falling international competitiveness.

Inflation can cause job losses

In general, during periods of demand-pull inflation, unemployment tends to be low and employment high. However, when inflation comes from the supply-side [cost-push inflation] firms might look to reduce costs to remain competitive, and substitute labour with capital. The extent of any job losses depends on the level of competition in both the product market and the labour market. For example, in imperfect labour markets with powerful unions, wages maybe pushed up through collective pay bargaining and jobs may be protected by the threat of industrial action. Hence, inflation is more likely to lead to job losses when both product and labour markets are competitive.

Distortion of the price mechanism

The price mechanism is central to the efficient operation of markets in a free market economy. For the price mechanism to allocate resources most efficiently prices will go up an go down. Changes in relative prices will signal to both consumers and producers, who will then adjust their behavior accordingly, and the market will clear at either a higher or lower price. General inflation, however, means that, on average, prices are rising, and this creates a kind of background noise and prevents markets from fully adjusting to relative price changes.

In a similar way, the phenomenon of 'money illusion' can also distort decision making. Money illusion exists when increases in monetary values (say, from inflation) are confused with increases in real values, and individuals and firms change their behavior, perhaps making themselves worse off.

Distortion of the tax system

Direct tax systems commonly have a tax free allowance, followed by tax bands with increasing tax rates. Assuming price inflation is matched by wage inflation, any inflation will push individuals into higher tax bands. This means that until tax bands are adjusted individuals could be worse off as a result of 'inflated' income.

Shoe-leather and menu costs

Shoe-leather costs are associated with high levels of inflation where individuals and firms prefer to have more of their money deposited in an interest bearing bank account, rather than keep it as cash. Cash held will receive no interest rate, and its value will fall more quickly than money receiving an interest rate. As a result of holding more money in deposit accounts, individuals and firms will need to make more of an effort to obtain frequent withdrawals in cash. Of course, in an increasingly cashless economy, the inconvenience of withdrawing cash is much lower.

Similarly, menu costs refer to the administration costs associated with re-pricing products (such as new price lists and 'menus'). As with shoe-leather costs, these are relatively small when inflation is creeping along at just a few percentage points a year, but when inflation is much higher than this, menu costs will become a burden due to the frequency of having to update prices. The significance of online selling also reduces the burden of price changes given that updating prices digitally is much less of an issue than for businesses which have to print and distribute real price lists, and because algorithms can do the heavy lifting associated with the re-pricing of products.

Balance of payments issues

Domestic inflation relative to overseas inflation will increase export prices relative to import prices. As with the erosion of the value of money, even small relative inflation rates will amount to significant price differences over time. Of course, depreciation in the external value of a currency (a falling exchange rate) will 'adjust' export prices downwards, and remove or reduce the effects of domestic inflation on the balance of payments.

Demand pull

How do economists explain demand-pull inflation?

Demand pull
Fiscal policy

How can fiscal policy influence aggregate demand?

Fiscal policy
Monetary policy

Is monetary policy more effective at controlling inflation?

Monetary policy