Costs of inflation
- Menu costs are the costs of repricing goods and services as prices change.
- Shoe-leather costs are the effort of holding less cash and shopping around for the best prices.
- Fiscal drag pulls earners into higher tax bands as money incomes rise with prices.
- High or volatile inflation raises uncertainty, which deters investment because firms cannot judge future returns.
- Rising prices can worsen international competitiveness if costs rise faster than in rival economies, so exports fall.
Key Idea
- Inflation redistributes from savers and lenders towards borrowers.
- Its impact depends on whether it is anticipated, and on its cause and rate.
Winners and losers
- Savers and lenders lose as the real value of money and repayments falls.
- Borrowers gain as the real value of their debt falls.
- Workers on fixed money wages lose real income if pay lags behind prices.
Example
- A saver puts £1,000 in an account paying a fixed 2% a year while inflation is 5%.
- The real return is roughly the nominal interest rate less the inflation rate.
- So the £1,000 buys about 3% less after a year, and the saver loses in real terms.
- A borrower on a fixed-rate loan gains, because the real value of the £ debt shrinks.
Anticipated or not
- Anticipated inflation lets agents adjust wages, prices and interest rates in advance, so the damage is limited.
- Unanticipated inflation causes the largest redistribution and uncertainty, as contracts cannot be revised in time.
- So it depends: low and stable inflation does little damage and can even signal healthy demand.
Exam technique
- Trace the effects on savers, borrowers, firms and the government in turn.
- State whether the inflation is anticipated and note its rate.
Common Mistake
- Do not assume all inflation is equally harmful.
- Unanticipated inflation does more damage than anticipated inflation.
Self review
- How does inflation affect savers?
- How does inflation affect borrowers?
- What is fiscal drag?
- Why does unanticipated inflation do more damage than anticipated inflation?
