inflation report

inflation report

The Impact of Inflation on the Economy

1. Introduction

In terms of a long-winded definition of inflation, it is the rate at which the general level of prices for goods and services is rising, and subsequently, falling purchasing power of money. It can also be described as a decline in the real value of money. Normally, in the developed world, it is measured by the Retail Prices Index (RPI) and the Consumer Prices Index (CPI). Both measure a basket of goods and services to monitor any change in price. There are positives and negatives for inflation and whether it has any benefiting effect for an economy has been argued for decades, even centuries economists. With inflation, debtors gain and creditors lose. Suppose you lend money at a fixed interest rate, if the inflation rate rises above the interest rate on your lending, then you are making a loss, as the value of the money you have lent has decreased and you are not compensated with any additional interest. On the other hand, the borrower gains because the money that has been borrowed can be repaid in the future with money that is worth less. Inflation can cause a redistribution of income. This can be seen with changes in the price of certain goods and services. If the price of a product increases at a rate above the average inflation rate, then there will be an increase in the demand for that product. This will cause consumers to shift resources from buying other goods and services to purchasing the product that has increased in price. Because of this, the demand for labor and materials will increase in that specific industry and there will be a rise in the price of inputs. This will lead to an increase in the price of that product yet again and the cycle will repeat. Demand Pull Inflation will occur because there will be an increase in aggregate demand, this will create an output gap where the limit of the economy’s production is exceeded. This will cause firms to put up prices and there will be an equilibrium price higher than the full employment equilibrium. This is an example where inflation can cause economic growth due to the fact that the inflated prices have forced an increase in production.

2. Causes of Inflation

– Redistribution of income: High inflation rates are damaging to firms that cannot anticipate the inflation as they may face cost increases that can’t be passed on to consumers. This reduces profits and can lead to a fall in investment spending. Uncertainty about the future is likely to cause consumers to increase savings and reduce borrowing so as to smooth their consumption over time. This additional saving is likely to finance government budget deficits, but it’ll also reduce current consumption spending. The inflation and subsequent reduction in consumption and investment can lead to unemployment.

– Loss of resources: Inflation involves increased uncertainty about the future. High inflation involves higher risks and, since risk is costly to reduce, higher risk implies higher resource usage. The recent global financial crisis was primarily the outcome of excessive and imprudent lending by banks. The globalization of markets meant that banks and other lending institutions were forced into relentless competition to increase profits and gain market share. The heightened competition led to greater risk-taking as institutions sought higher profits and increased market share. Inflation also changes the distribution of income. For example, higher inflation rates in the 1970s were associated with higher wage costs as workers sought to maintain their real standard of living. However, wage rate changes usually lag behind price changes, so workers end up earning less than before and are pushed into higher tax brackets. This reduces disposable income and the ability of consumers to purchase goods and services.

Inflation is primarily the outcome of a continuous increase in the cost of living. The burden of inflation can be divided into two types, namely economic costs and social costs. The economic costs of inflation include:

3. Effects of Inflation

If individuals are not aware of the inflation, it can stimulate a further reduction in unemployment than the one described above. This is because firms will assume that the increase in demand for their products is genuine and lasting and thus require a long-term expansion of their workforce. This will occur until the inflation rate becomes known and firms re-adjust their employment levels to the new higher level of unemployment.

Between the start of the inflation and a change in wage rates, the economy will experience a reduction in unemployment and an increase in the level of output. This is because, if the inflation is anticipated, an increase in production will be necessary to meet the higher level of aggregate demand. If the rate of inflation is higher than that anticipated, the rate of increase in production will have to rise to achieve the same effect. Therefore, the unemployment rate will reduce to a level lower than the natural rate.

4. Controlling Inflation: Monetary Policy

Using interest rates to control inflation, the Bank of England looks to keep inflation within 1 percentage point of a target rate, implemented by the Chancellor of the Exchequer. If inflation rises above this point, the Bank of England’s Monetary Policy Committee will look to reverse the trend by raising interest rates. Increased costs of borrowing will reduce consumption and investment, thus reducing AD. Firms’ competitiveness may also be damaged due to increased costs of borrowing, because of exchange rate interest. This may lead to reduced foreign investment and worsened net exports. This in turn will reduce AE and therefore inflation as resources are once again idling. The drawbacks of increased interest rates are the effects that they bear on mortgages and the housing market. High rates may lead to reduced disposable income for some families, and thus can increase inequality. High rates of interest have quite severe effects on the housing market, decreasing both house prices and housing construction due to the increased costs of mortgages. As around 70% of UK households’ wealth is tied up in housing, the negative wealth effects of the housing market can lead to large reductions in consumption and AE. In cases of severe recession brought about by high interest rates, the Bank of England may choose to use expansionary monetary policy to increase inflation and output. This could involve using quantitative easing, which will be discussed in more detail later.

Money is the single biggest factor in determining the behaviour of inflation. Given the low rate of unemployment and spare capacity in the economy, use of deflationary fiscal policy is likely to be ineffective because of the operation of automatic stabilizers. In such circumstances, the government would need to directly reduce the money supply. It is now generally accepted that the most effective way of controlling inflation is by operating monetary policy. This involves changing the level of interest rates or exchange rates to influence aggregate demand. Easier said than done, it is nevertheless the best way to control inflation as it directly influences potential output.

5. Conclusion

Inflation can have a big impact on all our lives and the lives of future generations. For some people, it means having to work harder for their money while hoping for the best in the near future. By contrast, others can take it easy because they know their money will come easily. However, we cannot run or hide from the fact that inflation has more negative effects than positive ones. The main disadvantage of inflation is that it is unpredictable, making long-term financial planning difficult. A party might consider taking a loan for certain costs, whether it is for education, health, or consumption. By the time the loan is repaid, they have to pay a higher cost due to inflation. The remaining cost is huge and far exceeds the initial cost when they took the loan. This also applies to debt countries. Debt countries usually face external debt, which is an investment for their development. Inflation can increase the debt and have a negative impact in the future. Because future loans are more expensive, it is possible that parties cannot fulfill their commitments, which is a bad image for a party that cannot take responsibility. On the other hand, creditors are reluctant to give large loans to debtors with high inflation rates, which further disadvantages debt countries. If this continues, investors will leave the country, tightening the money circulation. This situation is very disadvantageous for the development of debt countries and creates a bigger gap between them and low-debt countries in terms of welfare.