INFLATION AND THE ECONOMIC CLIMATE

Inflation

Definition

It is the percentage of the annual rise in the average price level of goods and services. It reduces the purchasing power of money (decline in the real value of money).

For consumers: It increases the cost of living.

For businesses: Impact on businesses is mixed (there are some advantages and also disadvantages).

Causes of inflation

1. Demand-pull inflation
2. Cost push inflation
3. Monetary inflation

Demand-pull inflation: This occurs when the excessive demand in the market pulls up the prices. Businesses may find themselves unable to cope with the ever increasing demand. For this reason, they might increase their prices, and ultimately leads to inflation in the long run.

Cost Push Inflation: Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins. There are many reasons why costs might rise: [1] expensive imports, [2] increase in the cost of raw materials, [3] increase in labour costs, [4] higher indirect taxes imposed by government (eg. Increase in excise duty and VAT).

Monetary inflation: This occurs due to the increase in the money supply. It causes inflation when the rate at which the increase in money supply is faster than the output of products. For example, excessive growth of money supply in UK may create inflation in UK economy.

Consequences of inflation

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. For example, budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs - and this may reduce planned capital investment spending.

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, which is another cost.

8. ‘Menu costs’ are the costs of constantly changing prices as in the literal example of reprinting the menu. But it’s not just the price labels on the goods, but the whole business system that has to be changed.

9. Wage negotiation. If there is inflation, workers will want pay rises. The actual time and cost of negotiating this, and making the necessary administrative changes can be quite high. Whilst managers are negotiating, they aren’t doing anything else.

10. Asset-price inflation. Houses, shares and other investments (even art & antiques!) often rise in price during inflation as investors look for a safe haven for their money. These prices then rise due to strong demand, which attracts further buying. So normal spending patterns are changed because of less spending on normal goods and services and more spending on assets. This switch reduces demand for normal businesses and creates an artificial ‘bubble’ in these other markets.

11. Trade. If the UK has higher inflation than competitor countries (which it isn’t now, but it has been for a lot of the last few decades) then UK prices gradually rise above imported prices. More imports are bought, so demand leaks out of the country and leaves UK businesses in a weak position. The same effect occurs with UK export businesses. The eventual effect may be a fall in the £ which puts prices back where they were, but leaves UK consumers worse off because they can buy fewer imports than before.

Competitiveness and Unemployment: Inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance. If inflation in the UK is persistently above the major trading partners, British exporters may struggle to maintain their share in overseas markets and import penetration into the UK domestic market will grow.