For the UK, price stability means ensuring that the price level increases gradually, by an average of no more than 2% per year. The official target is 2%, though there is a safety margin of +/- 1%. The Bank of England is forced to intervene if inflation falls outside of these limits.
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 is bad for 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 falling investment.
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, and the growth of price comparison sites, has considerably reduced the problem of search costs, making information freely and quickly available. Menu costs are 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 and creates inflation noise
When average prices rise, the price mechanism cannot effectively fulfill 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.
Deflation
Price deflation, which means falling average prices, can also cause severe economic problems, including the following.
Consumers may delay consumption
Consumers may wait for prices to fall even further, and this can have a negative impact on AD, output and incomes.
Real interest rates are pushed up
Given that nominal interest rates cannot fall below zero, falling prices cause real rates to rise. For example, if nominal interest rates are currently 5% and inflation is 1%, real interest rates are 4% (which is 5% – 1% = 4%). However, if the price level falls by 2%, real interest rates (5% – [-2%]) rise to 7%. Of course, nominal rates can be reduced, but deflation tends to put upward pressure on real rates.
Rising debt burdens
Deflation will cause debt burdens to rise for households that have borrowed in the past. Many consumer and corporate debts are fixed, including fixed mortgages and personal loans, and repayments do not fall as prices fall, making the real price of the debt rise. For firms, falling prices also create a debt burden because, although revenues fall, debt repayments may remain at the old level, increasing the real debt burden.
Recession
Deflation can significantly reduce economic confidence, and households and firms may be encouraged to save rather than spend, despite falling interest rates. As non-essential spending falls, economic activity will fall, creating a deepening recession that even near zero interest rates may not budge. Long-term recession, following a period of deflation is often referred to as the Japanese disease, given that, for a long period during the 1990s, Japan seemed trapped in a deflationary spiral.
Measuring price changes
Measuring changes in average price levels requires the use of a device called an index. It is impossible to keep an accurate record of every price change for every good and service in the economy at all times. In 1914, the UK Government began to monitor food prices to help protect workers during the First World War. In 1916, price checks on clothing, fuel and a few other items were added to generate a simple cost of living index. (Source: ONS).
Today, the UK uses a number of indices to track price changes, including the Consumer Price Index (CPI), which was introduced in 2003, and the much older Retail Price Index (RPI) which was introduced in 1947. Using an index allows a general picture to develop to show the average price change for a sample of goods and services, measured at monthly intervals.
The CPI is based on the European Harmonised Index of Consumer Prices (HICP) and its introduction in the UK allowed for more accurate inflation comparisons between the UK and Europe.
0 comments:
Post a Comment