The costs of inflation
Price inflation is regarded as a serious economic problem because it causes a number of significant costs to an economy, including the following:
It erodes the value of money and assets
A rise in the price level means, ceteris paribus, that money can buy fewer goods. If assets are stored in a monetary form, inflation means that asset values fall. This explains why, during inflationary periods, individuals often choose to put their wealth into physical assets, like property, rather than keep it in a monetary form in a bank account.
It redistributes income between groups
Inflation can create a random redistribution of income given that inflation does not have an equal impact on individuals and groups. For example, individuals who can protect their earnings or their assets from inflation will increase their income relative to those who cannot. Similarly, borrowers do better at times of rising prices because the real value of their repayments are reduced over time. Lenders need to charge a higher interest rate to compensate for the falling value of the repayments to them, and for the loss of liquidity suffered as the value of repayments fall.
It has a negative effective on the balance of payments.
The balance of payments may deteriorate because domestic inflation stimulates import spending, given that imports appear relatively cheaper, and dampens export sales, as exports appear more expensive abroad.
It causes uncertainty and fallinginvestment.
Firms respond unfavourably to inflation for several reasons. Firstly, inflation dampens consumer confidence and spending and reduces aggregate demand. Secondly, inflation increases costs and reduces competitiveness, which can lead to falling demand. Finally, firms may anticipate that interest rates will have to rise to deal with inflation, and this undermines business confidence. Falling confidence is likely to force firms to postpone capital investment.
It creates shoe leather and menu costs.
Shoe leather costs can be incurred during times of inflation when households and firms make an additional effort to seek out the best deals. These costs are also called search costs, reflecting the increased time spent attempting to find the lowest available prices. The Internet has made information freely and quickly available, and considerably reduced the problem of search costs. Menu costs are costs associated with having to regularly re-price products to bring them in line with general inflation.
It can create unemployment
Inflation can lead to a loss of jobs through its effect on costs. As costs rise firms may substitute labour with other factors, such as new technology.
Inflation distorts the price mechanism
When average prices rise, the price mechanism cannot effectively fulfil its role as a resource allocating mechanism. Markets work best when prices rise and fall, providing information about relative values, but if average prices rise continuously, with increases outweighing decreases, resource allocation is distorted. The distortionary effect is called inflation noise which can occur when consumers and producers misperceive relative prices and costs. The effect is most significant when the rate of inflation is excessive. When inflation rates approach zero, inflation noise is minimised.
It creates money illusion
Money illusion, also called inflation illusion, is a phenomenon that may arise when rising prices lead people to make irrational decisions. For example, if wages rise, workers may decide to work longer hours, but if inflation erodes the value of the wage rise they have been fooled into working longer.
Also:
