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Monetary Policy - Inflation - CostsExplanationSince the beginning of the 1980s, inflation has superseded unemployment as the principal economic target for the government. This didn't happen just because they were bored with targeting unemployment; there must have been good reason for them to do this. The principal reason for switching was because of the costs of inflation to the economy, and because they felt that if they could get low and stable inflation, full employment would naturally follow. The seriousness of the costs of inflation depends mainly on whether it is anticipated (expected) or not. If people anticipate the inflation, then the effects will be less, as they will build these expectations into their behaviour. Nevertheless, there will be costs for firms who have to keep changing their prices. These are called 'menu costs'. As individuals we will be less likely to hold as much cash, as it loses its value quicker when there is inflation. This means we will have to go to the bank more often to get cash out. These are called 'shoe leather costs'. Even the Chancellor will be affected as the inflation will cause distortions to the tax system and affect the amounts the government receives from each type of tax. The costs are more serious if the inflation is unanticipated. If this happens, then we haven't allowed for it, and so wage levels get distorted. Even more serious than that (it's getting serious now!) is the effect on prices. Prices are fundamental to a market economy working efficiently, and if price changes become less predictable then the 'price signals' will not work properly and this can lead to an inefficient allocation of resources - allocative inefficiency. The higher the level of inflation, the more difficult it is to predict. This will almost certainly lead to higher costs. The moral of this is: low inflation - good, high inflation - bad! For more detail on each of these, why not have a look at the theories section for the costs of inflation. |
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