Monetary Policy - Inflation - Costs

Theory 2 - Unanticipated inflation - did it catch you unawares?

When people don't predict inflation, they don't expect it! This can have a number of effects on the economy, as it hasn't been built into people's behaviour. This can cause a number of distortions. The main costs of unanticipated inflation are:

• 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.
• Resource costs - if you see that the price of something that you buy has gone up, then that causes a dilemma. Is it just that item that is more expensive? Or is it all the other brands as well? In other words, has there been a relative price increase (one thing relative to others), or a general price increase (everything increasing in price). If it is a general price increase then you would probably just buy it anyway and then moan about inflation. However, if it is a relative price increase you may want to switch brands.
  Inflation can distort price signals in the economy. These price signals are fundamental to the efficient workings of markets and inflation can adversely affect them. You will now have to go to a lot more effort to check you are paying the right price for the things you are buying.Firms and individuals may have to go to a lot of effort to avoid the effects of inflation and this is time that could be spent much more effectively on other things. These resource costs create allocative inefficiency. The higher the level of inflation, the less predictable it is, and therefore the worse these costs.
• 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.
• Real Incomes - an explanation:
  It may be useful to spend a short time looking at how inflation can affect incomes. Money is a medium of exchange - just that, it is merely the means through which we acquire the goods and services we want. The amount we give up to acquire those goods is therefore not that important, what is important is what we get for our money. Real income takes into consideration the impact of price changes on our spending power. Consider the simple example below to highlight this:

Assume that an individual earns £200 per week. This individual buys nothing else with their money but bananas. Bananas are currently £2 for a bunch of five. The real income of our individual is the 100 bunches of bananas that they can purchase with their current income.

If, as a result of inflation, the price of bananas rises to £4 per bunch and incomes do not change, then our individual is now worse off; they can only buy 50 bunches of bananas. We can say that their real income has fallen. Of course in reality, peoples nominal income rises as well. If this person`s nominal income rose to £360 per week then they will be able to purchase 90 bunches of bananas. But, they are still worse off than before. So if wages rise at a rate that is less than the rate of inflation, people's real income will decline.

In cases where inflation has risen to levels termed 'hyper-inflation' (for example in Germany during the 1920s where price rises, at their maximum, increased by 3.25 million times per month) there were reports of people who would order a restaurant meal and pay for it before they received it because by the time they finished eating their meal, prices would have risen several times!!

There have also been cases of hyperinflation in our own times. In Yugoslavia during the breakdown of the communist regime and the Balkan wars of the 1990s, inflation reached 5 quadrillion percent between October 1993 and January 1995 - that's 5 with fifteen zeroes after it. 5,000,000,000,000,000! With inflation at such rampant levels few people have any confidence in the currency and refuse to accept it in payment or to use it for payment. Money, in these circumstances, ceases to retain its qualities or functions and has to be changed!

So, how much money you have in terms of the figures mean very little - it is what you can buy with it that is important. Would you rather be a millionaire in the UK or a millionaire in Turkey?(to help you - at the time of writing the exchange rate of the Turkish Lire and the UK pound was 1 GBP = 2264122 TRL!)