Consequences of Inflation
Economics: Edexcel A A Level, topic 3.1.5
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.
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.
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.
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.
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!
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.
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?
Test yourself on Consequences of Inflation
Which of the following is a consequence of inflation for firms?
What are menu costs?
Which of the following factors would worsen the effects of inflation for an economy?
What can expectations of higher inflation lead to?