External environment - Economic indicators

Theory 3 - Inflation - who does it affect?

Inflation can have significant effects on the economy and here we look at some of the possible costs of inflation:

• Shoe-leather costs - if the value of money is falling because of inflation, then people will want to keep their money in a form earning interest for as long as possible. This means more trips to the bank to get cash, and hence the term shoe-leather costs.
• Menu costs - these are the costs to firms of having to constantly revise their price lists, or price labels. Higher inflation means more frequent revision of prices and this can be costly as all your customers have to be notified. The more customers you have the more expensive this is!
• Tax distortions - both direct and indirect taxes are affected by inflation. Many indirect taxes are a fixed amount. This is true of all excise duties on cigarettes, petrol and alcohol. If the amount is fixed, then inflation will gradually erode the amount the Chancellor receives in real terms. The price of the good will be going up, but the tax won't!
• Uncertainty - higher inflation tends to fluctuate more and be less predictable. This makes life very difficult for firms who want to plan ahead as much as possible. This uncertainty may particularly affect their investment plans. Many investment projects take a long time before they generate returns. If the level of inflation is unpredictable, then firms will find it more difficult to work out if the investment will be profitable. In that case they may simply not bother to take the risk. So higher inflation may adversely affect investment, and this will slow down economic growth in the long run.
• Redistribution - inflation creates an arbitrary redistribution of income, and is basically unfair. People who have borrowed money will be better off as they have less to pay back in real terms. Savers, on the other hand, will be worse off as inflation is eroding the value of their savings. People on fixed incomes or with fixed savings like pensioners may be the worst off. It can be really demoralising to have saved all your life for retirement, only to find that the money you have saved is worth less and less every year thanks to inflation.
• Balance of payments / competitiveness - markets are becoming increasingly globalised and firms have to compete with other firms all over the world. If our inflation rate is faster than other countries, then it makes it much more difficult to compete. This will tend to make exports suffer, but at the same time imports become relatively cheaper. Overall the balance of payments will worsen.