Inflation 2

Costs and consequences of inflation

• Inflation will cause the standard of living of those on fixed or near fixed incomes to fall- this will have the biggest impact on those in low income employment or on welfare benefits

• A country’s competitiveness will be reduced by inflation as exports will cost more to buy and imports will be cheaper. If exports fall and imports rise, then this could create a deficit in the BOP and increase unemployment

• Inflation discourages saving because of the value of savings fall - this makes it more attractive to spend (creating demand pull inflation) before prices rise further

• A reluctance to save creates a shortage of funds for borrowing and investment, which means that its harder for firms to make improvements e.g. buy new machinery - if interest rates go up to reduce inflation, this will also reduce investment

• Inflation creates uncertainty for firms as rising costs will reduce investment- harming future growth

• An extreme case is hyperinflation where inflation grows very quickly to high levels - it’s often the result of governments creating too much money

Deflation isn’t a good thing

When the rate of inflation falls below 0% it’s called deflation

Deflation is often a sign that the economy is doing badly, as its usually caused by falling aggregate demand and increased unemployment

However, deflation can be caused if firms’ costs fall and these benefits are passed on to consumers in the form of lower prices

Deflation can cause big problems for example, if consumers think that prices are falling then they may choose not to spend in the hope that prices will fall further

Less spending and lower prices will also mean lower profits for firms and reduced economic growth

Inflation of 2% is acceptable

In the UK, the bank of England and the government consider low and stable inflation (up to 2%) to be acceptable- excessive inflation (above 2%) is undesirable and can cause problems

Government uses a combination of monetary policy, fiscal policy and supply side policies t try and keep the rate of inflation at 2%. However, to achieve the government has to make trade offs between their inflation target and their other three main economic objectives

Some monetarists believe that bringing down inflation in the short run will help the government in the long run to achieve the other main economic objectives

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