Wednesday, February 28, 2007

Costs of Inflation in UK

Why does MPC and UK government worry about inflation? What are the reasons for having an inflation target of CPI 2% ?

Economics Costs of Inflation

1. Menu costs.

This is the cost of changing price lists e.t.c. However with modern technology this is less significant these days. E.g. Computerised bar codes make it easier to update.

2. Inflation creates uncertainty and confusion.

When inflation is high it also tends to be more volatile. It becomes more difficult for firms to predict future prices and costs, therefore they tend to reduce or delay investment decisions. Therefore this tends to adversely effect economic growth in the long term.

3. Lower Competitiveness

High inflation in the UK makes the UK less competitive compared to other countries. This will reduce demand for UK goods, causing lower growth and possibly balance of payments problems. This is increasingly important with the globalisation of the world economy. If we do lose competitiveness in the long term it is likely to lead to devaluation of the UK exchange rate.

4. Inflationary growth is unsustainable.

In the 1980s the UK experienced economic growth above the long run trend rate, however this also caused inflation leading to a boom and bust economic cycle. Keeping inflation close to the government’s target of 2% is one of the best ways of avoiding inflationary growth and maintaining sustainable economic growth like the UK has experienced since 1992.

5. Inflation reduces the value of savings.

This is because inflation erodes the value of money. This is likely to effect pensioners the most. Therefore inflation is thought to cause a redistribution of income within society from savers to borrowers. However this is only a problem if inflation is higher than the rate of interest. If interest rates are above the value of inflation then savers can still maintain the value of their savings. (so long as they don’t keep it in cash under their bed). This is not really a significant problem in the UK. Real interest rates usually remain positive.

6. Shoe leather costs.

This is the cost of looking around for the best deal. When inflation is high it becomes more difficult to know best deals. However this is only really a problem for very high levels of inflation.


mcr said...

Your definition of shoe-leather costs of inflation is incorrect. You define 'search costs' as shoe leather costs. While many people do put this forward as a definition the correct one is that shoe leather costs is the cost of managing money. Holding cash becomes costly as inflation rises because it loses value. Therefore holding money in interest bearing accounts becomes more attractive. However this necessitates more trips to the bank to obtain cash for transactions. The higher the rate of inflation the more important it is to only withdraw small amounts of cash. Hence shoes are worn out going to the bank to make more frequent withdrawals. Seee 'UK inflation and monetary policy' Heathfield and Russell

Tejvan Pettinger said...

thanks mcr