What’s Wrong With Inflation?
It’s a matter of degree; 25% inflation is much worse than 5% inflation. Some countries (eg Russia and Serbia) have recently had hyper-inflation with prices rising by up to 1000% pa! Low inflation, such as the 2% or so the UK has at present, is not a real problem.
The UK has had a big problem with inflation in the past. It rose to 28% in the late 1970s. This caused significant problems with growth and employment. The memory of this time makes the government very determined now to keep inflation under control. Why?
1. Inflation distorts prices between different time periods. Normally, people save some money, and there is a balance between savings and spending. Savings go to banks where they become loans for business investment. If there is inflation, you’re better off spending the money now before it loses its value, so consumption now rises at the expense of consumption later; savings are money you plan to spend later.
2. Instead of saving, consumers may start borrowing. £10 000 borrowed now will buy lots of things, and by the time you repay it in a few year’s time, the £10 000 is worth less, and is probably easier to repay if your salary has risen because of inflation. So consumers tend to borrow more and spend even more.
3. Interest rates rise. If a lender normally wants 5% to let someone else use the money for a while, and inflation is also 5%, then the lender will want 10%. This puts up business costs and makes borrowing less and therefore investment less; less investment means less growth and employment.
4. Inflation causes uncertainty which increases risk. Higher risk means businesses are less likely to invest, with the results mentioned in 3.
5. Inflation re-distributes wealth and income. People with fixed incomes eg some pensioners see the real value of their income fall (they become worse off) and other people get pay rises to compensate for inflation (they become better off). Wealth moves from savers to borrowers eg house price inflation makes the owners of houses much better off, and the mortgages become easier and easier to repay.
6. Input prices (raw materials, wages and supplies) rise so business costs rise. Wages are often the largest business cost, and there could be a danger of a ‘wage-price’ spiral where rising costs leads to higher prices, workers ask for a pay rise in compensation, so costs rise again, so prices rise again, and so on.
7. ‘Shoe-leather’ costs. Because prices are always changing businesses and consumers spend a lot of time looking for the best price (walking up and down the high street) which is a cost and they may not find the best deal,