Assignment No.

2 UMER HAMID ENAM BEM-1079 SUBMITTED TO: KHALID JAMIL ANSARI

Why does inflation matter?

The impact of inflation on individuals and businesses depends in part on whether inflation is anticipated or unanticipated: Anticipated inflation: When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects. For example, trade unions may exercise their collective bargaining power to negotiate with employers for increases in money wages so as to protect the real wages of union members. Households may also be able to switch savings into deposit accounts offering a higher nominal rate of interest or into other financial assets such as housing or equities where capital gains over a period of time might outstrip general price inflation. In this way, people can help to protect the real value of their financial wealth. Companies can adjust prices and lenders can adjust interest rates. Businesses may also seek to hedge against future price movements by transacting in forward markets. For example, most of the major airlines buy their aviation fuel several months in advance in the forward market, partly as a protection against fluctuations in world oil prices. Unanticipated inflation: When inflation is volatile from year to year, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future. Unanticipated inflation occurs when economic agents (i.e. people, businesses and governments) make errors in their inflation forecasts. Actual inflation may end up well below, or significantly above expectations causing losses in real incomes and a redistribution of income and wealth from one group in society to another.

Money Illusion It is a fact of life that people often confuse nominal and real values in their everyday lives because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income. Money illusion is most likely to occur when inflation is unanticipated, so that peoples expectations of inflation turn out to be some distance from the correct level. When inflation is fully anticipated there is much less risk of money illusion affecting both individual employees and businesses The Main Costs of Inflation What are the main costs of inflation? Why is the control of inflation given such a high priority in macroeconomic policy-making? Supporters of tough inflation control would support the arguments made in this quote in a speech delivered in 2002 from Mervyn King. The case for maintaining price stability It is clear that very high inflation in extreme cases hyperinflation can lead to a breakdown of the economy. There is now a considerable body of evidence that inflation and output growth are negatively correlated in high-inflation countries. For inflation rates in single figures, the impact of inflation on growth is less clear. Source: Mervyn King, Governor of the Bank of England

In explaining and assessing the costs of inflation, we must be careful to distinguish between different degrees of inflation, since low and stable inflation is perceived to have less of a damaging effect than hyper-inflation where prices are out of control. Another important part of your evaluation is to be aware that inflation will have differing effects both on individuals and also the performance of the economy as a whole. Impact of Inflation on Savers: Inflation leads to a rise in the general price level so that money loses its value. When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if nominal interest rates are lower than inflation leading to negative real interest rates. For example a saver might receive a 3% nominal rate of interest on his/her deposit account, but if the annual rate of inflation is 5%, then the real rate of interest on savings is -2%. Inflation Expectations and Wage Demands Inflation can get out of control because price increases lead to higher wage demands as people try to maintain their real living standards. Businesses then increase prices to maintain profits and higher prices then put further pressure on wages. This process is known as a wage-price spiral. Rising inflation leads to a build-up of inflation expectations that can worsen the trade-off between unemployment and inflation. Arbitrary Re-Distributions of Income Inflation tends to hurt those employees in jobs with poor bargaining positions in the labour market - for example people in low paid jobs with little or no trade union protection may see the real value of their pay fall. Inflation can also favour borrowers at the expense of savers as inflation erodes the real value of existing debts. And, the rate of interest on loans may not cover the rate of inflation. When the real rate of interest is negative, savers lose out at the expense of borrowers. Business Planning and Investment More generally, inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs - and this may reduce planned capital investment spending. Lower investment then has a detrimental effect on the economys long run growth potential Competitiveness and Unemployment Inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance. If inflation in the UK is persistently above our major trading partners, British exporters may struggle to maintain their share in overseas markets and import penetration into the UK domestic market will grow. Both trends could lead to a worsening balance of payments. The UK government believes that monetary stability (i.e. low inflation) is a precondition for sustained economic expansion. As the chart below demonstrates, the UK has made progress in reducing the volatility of its inflation rate in the last decade. The era of high and volatile inflation may have come to an end. Author: Geoff Riley, Eton College, September 2006