The costs and consequences of inflation and deflation

Overview

Inflation redistribute income between borrowers and lenders, unanticipated inflation do more damage than inflation that everyone expects and menu costs and shoe-leather costs.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   How does inflation redistribute income between borrowers and lenders?

   Model answer

   A loan fixes the amount of money to be repaid, but inflation reduces what that money will buy, so the borrower repays a sum of lower real value than was borrowed. The lender receives less purchasing power back than was lent, so real wealth is transferred from lender to borrower. The transfer only happens to the extent that the inflation was unanticipated, since a lender who correctly foresees it will demand a higher nominal interest rate as compensation.

2. 2

   Why does unanticipated inflation do more damage than inflation that everyone expects?

   Model answer

   Anticipated inflation can be built into contracts: lenders raise nominal interest rates, workers negotiate matching pay rises, and pensions and benefits are index-linked, so real values are broadly protected. Unanticipated inflation catches all these arrangements at the wrong settings, so real returns, real wages and real benefit values are cut arbitrarily depending on when each contract was last set. The damage therefore comes from the surprise and the resulting arbitrary redistribution, not from the level of the rate itself.

3. 3

   Who tends to lose most from inflation, and why?

   Model answer

   Savers holding money or fixed-interest assets lose, because the real value of both the capital and the fixed income falls. People on fixed nominal incomes, including some pensioners and those on payments that are not uprated promptly, lose because their purchasing power declines month by month. Workers with weak bargaining power lose because they cannot obtain compensating pay rises. Those who gain are borrowers, particularly holders of large fixed-rate debts, and owners of real assets whose money value rises with the general price level.

4. 4

   What are menu costs and shoe-leather costs?

   Model answer

   Menu costs are the resources firms use in changing prices: reprinting price lists and labels, updating systems and informing customers. Shoe-leather costs are the resources people use in economising on holdings of cash whose value is eroding, such as making more frequent trips to move money between accounts and spending time managing balances. Both are small at low inflation rates but rise steeply as inflation accelerates, and both represent effort diverted from productive activity.

5. 5

   How does inflation damage the efficiency with which resources are allocated?

   Model answer

   Firms and consumers rely on relative prices to signal where resources are scarce and where they are abundant. When the general price level is rising rapidly and unevenly, it becomes hard to tell whether a particular price has risen because that good is genuinely scarcer or merely because everything is rising. Firms may expand capacity in response to what turns out to be a purely nominal signal, misallocating investment. The noisier the price signal, the less efficiently the market performs its allocative function.

6. 6

   Analyse the effect of high domestic inflation on a country's international competitiveness.

   Model answer

   If domestic prices rise faster than those of trading partners, domestically produced goods become dearer relative to foreign goods at any given exchange rate. Exports become less attractive to foreign buyers and imports become more attractive to domestic buyers, so export volumes fall and import volumes rise and the current account deteriorates. Employment in traded sectors falls as those firms lose sales in both markets. The effect can be offset if the exchange rate depreciates by enough to restore relative prices, and under a floating rate this adjustment tends to occur over time, but it is neither immediate nor reliable. Under a fixed exchange rate no such offset is available, so the loss of competitiveness persists until domestic costs are brought down directly.

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