Consequences of inflation/deflation

Consequences of inflation/deflation

1. Reduced international competitiveness - If a country has a relatively higher inflation rate than its trading partners, then its exports will become less competitive, leading to a fall in exports and a deterioration in the UK current account.

2. Confusion and uncertainty - When inflation is high, people are more uncertain about what to spend their money on. Also, when inflation is high, firms are usually less willing to invest - because they are uncetain about future prices, profits and costs. This uncertainty and confusion can lead to lower rates of economic growth over the long term.

3. Boom and bust economic cycles - High inflationary growth is unsustainable and is usually followed by a recession. By keeping inflation low, it enables a long period of sustainable economic growth.

4. Menu costs - This is the cost of changing price lists. When inflation is high, prices need frequently changing which incurs a cost.

5. Shoe leather costs - To save on losing interest in a bank, people will hold less cash and make more trips to the bank.

6. Income redistribution - Inflation will typically make borrowers better off and lenders worse off. Inflation reduces the value of savings, especially if the savings are in the form of cash or bank account with a very low interest rate. Inflation tends to hit older people more. Often retired people rely on the interest from savings. High inflation can reduce the real vaue of their saving and real incomes.

7. Cost of reducing inflation - High inflation is deemed unacceptable therefore governments/Central Bank have to reduce it. This involves higher interest rates to reduce spending and investment. This reduction in AD will lead to a decline in economic growth and unemployment.

8. Fiscal drag - The amount of tax we pay increases if there is inflation. This is because with rising wages more people will slip into the top income tax brackets.

9. Falling real incomes - In periods of nominal wage restraint, even a small increase in inflation can lead to a fall in real wages.

10. Bondholders lose out - In the 1970's, inflation was much higher than expected and higher than the nominal interest rate. Therefore, bondholders saw a fall in the real value of their bonds. This made it easier for the government to pay back their debt, but it means investors lost out. Also, it makes investors less willing to purchase government bonds in the future.