Download Discuss the economic consequences of inflation?

Discuss the economic consequences of inflation?
In this essay the economic consequences of inflation on the economy will be
considered. Inflation is a continuous rise in average price levels including
wholesale and factor prices. There are two main causes of inflation; cost push
and demand pull inflation. Cost push inflation occurs when the price level is
pushed up by sustained increases in the cost of production which is independent
of aggregate demand. Demand pull inflation occurs when price increases as a
result from an excess of demand over supply.
Firstly, high Inflation erodes the real value of people’s savings. It transfers
wealth from savers to borrowers. Unanticipated inflation causes arbitrary
redistribution of wealth and incomes meaning any wealth that does not rise
rapidly with inflation loses its real value. This happens when people do not
predict inflation and fix index linked pay, prices and contracts.
Secondly, inflation leads to people bringing forward their purchase to avoid
higher prices. This leads to increased consumption which creates higher prices
resulting in the demand for higher wages. This increases production costs for
firms who pass on the higher costs to consumers in the form of higher prices. On
the other hand some firms are driven out of the industry due to elastic demand
creating job losses and increasing unemployment. On the contrary, low and
steady inflation results from extra pressure from aggregate demand growth. This
helps create growth and steady increases in sales. This means companies know
demand will grow helping create jobs which lower the unemployment levels.
Inflation causes many people to be less well off as people on a fixed income see
their purchasing power decrease. This typically affects pensioners as the real
value of their income decreases. People in weak unions and non-unionized labor
markets also suffer as they may be unable to maintain fast enough pay rises as
other workers do thus losing their share of national income. Similarly there are
many psychological and political costs. Price increases are deeply unpopular and
people feel they are worse off; even if their incomes rise above the rate of
inflation.
Menu and shoe-leather costs also increase due to inflation. Shoe leather costs
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include the cost of searching for the best price in the market. This occurs
because inflation brings perpetual uncertainty as to what the latest prices are.
Menu costs are the cost of changing price lists, catalogues and advertising as
well as the cost of maintaining and replacing/updating vending machines which
is more frequent if inflation is high. As a result of greater menu and shoe leather
costs firms have a higher production cost making them less competitive.
High inflation may be harmful to an economy as it results in a reduction in the
price competitiveness of the economy in international markets. Exports will
become relatively expensive and imports cheaper. This leads to the balance of
payments suffering as consumers switch to cheaper substitutes. This creates a
bad current account draining an economies foreign reserve. This creates a crisis
as confidence in the currency decreases leading to an outflow of hot money
causing the currency to collapse. In contrast if the rate of inflation is similar or
lower than that of other countries then inflation can either have a positive or no
effect.
If inflation occurs at a higher rate than the European Union we cannot join as the
European Union countries import over 60% of British trade. As we are one of the
most importing nations it is vital our inflation rate stays below or at the world
average. On the other hand the government benefits from extra revenues
generated from inflation through Fiscal Drag. As inflation pushes up wages we
automatically pay more tax and go up to the higher tax bands. Similarly we also
spend more and therefore pay more VAT.
Inflation causes the breakdown of the price mechanism as prices act as a signal
for the allocation of resources. Therefore the higher prices will lead to an
increase in production by firms. However, if prices increase by 8% then costs will
also rise by 8%. This signals that suppliers should increase supply and therefore
inflation can be misleading as no extra revenue will be gained. Some firms seeing
the rising demand and increased prices for their product may be encouraged to
expand their output. On the other hand, firms may benefit from low real interest
rates and the opportunity to cut real wages they pay. When inflation is low,
nominal and real rates of interest are usually low. Also a fall in real interest rates
will reduce firms’ current costs making future investment cheaper and increase
consumer demand for their products.
Unanticipated inflation causes uncertainty for businesses, lenders and borrowers.
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Industry cannot plan investment and is unsure about how fast costs particularly
labor; will rise.
Unpredictable inflation brings huge risks and so puts firms off from investing.
Thus inflation damages potential growth through damaging investment and
profits. In contrast low and steady rates of anticipated inflation can be helpful.
Industry, government and unions all know the rate of inflation and can set price
increases, wage claims and tax increases at levels close to anticipated inflation.
Contracts and interest rates can be calculated so no one loses out or is forced
into bankruptcy.
The Monetary Policy Committee responds to high inflation by imposing higher
interest rates which have a negative effect on output and investment. On the
contrary the economy benefits from low and stable inflation as there is greater
macroeconomic stability and improved efficiency.
Overall it can be concluded that the economic cost of inflation depends on four
factors. Firstly, the degree of inflation as inflation is more costly if it is high and
variable.
Secondly, the costs are variable depending on whether inflation is anticipated by
consumers and produces. Furthermore, the costs differ if inflation is greater in
one country than in another to whom it trades. Finally, the costs are dependent
upon whether the exchange rate adjusts to restore lost price and cost
competitiveness for exporters.
From this it can be argued that low, steady and predictable rates of inflation can
be beneficial to an economy. This is because it increases consumer confidence
and keeps a sufficient wage differential as incomes rise each year. Stable
inflation also helps an economy grow and increase the revenue generated by
the government. Inflation also promotes economic growth and increases a
countries productive capacity.
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