3.1.5

Consequences of Inflation

Test yourself

Consequences of Inflation

The consequences of inflation can have varied impacts on households, firms and the wider economy. These can be more severe if the inflation is unexpected and if firms, for example, haven't had a chance to plan.

Illustrative background for Consequences for consumersIllustrative background for Consequences for consumers ?? "content

Consequences for consumers

  • For individuals, inflation will erode the real value of money. That is to say, real incomes will fall, as the purchasing power of incomes falls. So standard of living also falls.
  • Inequality rises because the more skilled workers can negotiate nominal wage increases that keep pace or outstrip inflation.
  • Cash loses value more quickly. This means that some consumers take more trips to the bank ('shoe leather' costs).
  • Menu costs are the costs firms face of keeping prices updated in shops.
Illustrative background for Impact on savers and borrowersIllustrative background for Impact on savers and borrowers ?? "content

Impact on savers and borrowers

  • Savers lose out because the real interest rate (nominal interest rate minus inflation) falls as inflation rises.
  • Borrowers gain because the real interest rate falls.
  • Indebtedness falls because the real value of debt falls as inflation erodes the real value of repayments.
Illustrative background for Consequences for firmsIllustrative background for Consequences for firms ?? "content

Consequences for firms

  • Business uncertainty – volatile prices means firms may reduce investment because it is riskier.
  • Falling international competitiveness – a high inflation rate vs main trading partners will mean a country's exports will be less internationally competitive.

Consequences of Inflation (Cont.)

The consequences of inflation can have varied impacts on households, firms and the wider economy. These can be more severe if the inflation is unexpected and if firms, for example, haven't had a chance to plan.

Illustrative background for The role of expectationsIllustrative background for The role of expectations ?? "content

The role of expectations

  • If inflation expectations rise, this can cause people to spend now to avoid the future higher prices.
  • This could lead to demand rising, causing prices to rise even further.
  • Expectations of higher inflation could cause higher inflation: a self-fulfilling prophecy!
Illustrative background for Wage-price spiralIllustrative background for Wage-price spiral ?? "content

Wage-price spiral

  • As inflation rises, people start to expect higher inflation.
  • This leads to them asking for higher nominal wage rises to keep pace with the rising cost of goods in shops.
  • Firms may grant this to begin with, but then as their costs are also rising, they may have to pass this on to consumers with higher prices. So they demand higher wages again.
  • This can become a vicious spiral.
Illustrative background for Other factorsIllustrative background for Other factors ?? "content

Other factors

  • The consequences of inflation depends on a number of factors:
    • Is it unexpected or expected ?
    • Is it a temporary or persistent problem?
    • The extent to which workers have negotiation power in terms of unions or skill level.
    • What is happening to nominal interest rates via the central bank response?
    • What is happening to inflation rates in the rest of the world?

Jump to other topics

1Introduction to Markets

2Market Failure

3The UK Macroeconomy

4The UK Economy - Policies

5Business Behaviour

6Market Structures

7A Global Perspective

8Finance & Inequality

9Examples of Global Policy

Go student ad image

Unlock your full potential with GoStudent tutoring

  • Affordable 1:1 tutoring from the comfort of your home

  • Tutors are matched to your specific learning needs

  • 30+ school subjects covered

Book a free trial lesson