Inflating Away Our Debt

Inflation reduces the value of money. This reduces the real value of your debt and also the real value of your savings. Therefore periods of high inflation tend to be good news for borrowers, but bad for savers. This is particularly the case if we have high inflation during a period of very low interest rates.

Inflation and Interest Rates since 1900

In periods where inflation is higher than interest rates, savers are losing out.

UK 2011

From one perspective, it is curious that with inflation of 5%, investors are very willing to buy UK bonds pushing interest rates down to 2.2% on 10 year bonds (Nov, 2011). What this means is that investors prefer to hold bonds with a negative real interest rate rather than use their funds to invest in other areas.

The good news for the UK is that with inflation of 5%, we are effectively 'inflating' away part of our debt. With inflation it is much easier to reduce your debt to GDP ratio.

Simple Example Showing Affect of Inflation on Debt.

• Suppose government borrow £1,000bn and nominal GDP is £1,000bn.
• Supposed tax revenues = £400bn (40% of GDP)
• The debt to GDP ratio is 100%.

• Suppose then we have inflation of 100%, and the level of former debt stays at £1,000bn.
• Because of inflation, nominal GDP increases to £2,000bn.
• The debt to GDP ratio will fall to 50%
• Also, if tax rates stay the same, tax revenue will increase to £800bn, making it easier to meet debt interest payments.

This scenario, is bad news for savers who see a real fall in the value of their savings. In the above case, savers will see the value of their bonds fall by 50%. This kind of inflation is effectively a partial default.

But, for the government and borrowers, it is a 'lucky' event which makes the task of debt reduction easier. However, if a country gains a reputation for having 'unexpected inflation' it will become more difficult to sell future debt. It means in the future bond investors will demand higher interest rates to compensate for risk. - There are only so many times you can get away with 'inflating away your debt'

Usually, the threat of inflation would push up bond yields as investors don't want to have this kind of negative interest rate. However, at the moment, pension funds don't want to invest in the stock market or invest in long term capital investment. They only want the security of government bonds. Therefore, in the current liquidity trap, the government can take advantage of borrowing at low interest rates.

Also, part of the reason that investors are willing to buy bonds at such low interest rates, is that they really do expect inflation to fall next year. The current inflation of 5% in 2011 is due to temporary factors such as higher taxes and impact of devaluation. Because markets expect inflation to fall next year, they are more willing to hold UK bonds.

Also, markets fear UK growth will be very low. This risk of a second recession means that the stock market and other investments are still unattractive. Pension funds would rather have the security of bonds rather than risk putting money elsewhere.

Bond yields have also benefited from

• The governments stringent spending cuts.
• UK yields have also been helped by having a lender of last resort (unlike Italy).

Inflation Unfair on Savers

Inflation invariably reduces real wealth of savers. Many pressure groups representing savers argue for immediate action to protect the value of their savings i.e. higher interest rates to reduce inflation and increase real interest rates.

However, the government and Central Bank have to weigh up the different costs.

It is unfortunate the middle classes see a small fall in the value of their savings. However, arguably it would be a much bigger cost to society, if higher interest rates pushed economy back into recession and a significant rise in unemployment.

Low interest rates reduce living standards, but it is not comparable to the reduction in living standards from unemployment and a prolonged recession.

Savers Also need Economic Growth

Savers are getting such a poor deal because of feeble prospects over economic growth. If the economy recovered with strong economic growth, pension funds would have the confidence to invest in shares and capital investment. They wouldn't feel tied to buying bonds with negative real interest rates.

Therefore, although it is unfortunate savers have negative real interest rates, it is definitely not in their interest to have a sudden rise in interest rates which pushes the economy back into recession.

Related

• Definition of inflation
• Costs of inflation
• Historical interest rates
  

Advantages of inflation

There are many Disadvantages of inflation.

Are there any advantages of inflation?

Firstly it is interesting to note the government's target for inflation is CPI = 2% +/- 1. They have a target of 2% rather than 0%

If inflation is 0% or lower (deflation there can be several disadvantages)

• Deflation can cause lower spending. The value of money is increasing so people wait before buying goods.
• A small amount of inflation makes it easier for the relative price of goods to update.
• Deflation can cause real wages to rise above the equilibrium level. Workers resent a cut in nominal wages. Therefore a moderate amount of inflation enables an increase in nominal wages, without causing excessive real wage rises.

to summarise there are some advantages of having a low rate of inflation e.g. 2%. However, as inflation rises above 2% we start to see the disadvantages outweighing the advantages
Problems recovering from recession

Inflation and the Function of Money

Readers Qu. EXPLAIN HOW INFLATION AFFECTS THE FUNCTIONS OF MONEY

Money is said to have four functions


1. Medium of Exchange - used for buying and selling goods.

2. Store of Value: We value goods and wealth through money. Money makes it easy to compare goods

3. Standard of Deferred Payment: Money is used to pay back debt.

4. Unit of Account: prices and accounting records use money


Inflation means an increase in the general price level. An inflation rate of 10% means that the average price level rises by 10%. Inflation means that the value of money decreases. If goods are more expensive a £10 note will buy less over time.

Inflation reduces the effectiveness of money as a medium of exchange. High inflation means that it becomes difficult to place a value on goods because the value of money is always falling. In extreme cases of hyper inflation prices can rise so much that money becomes worthless and people resort to a barter economy. e.g Hungary 1946, Germany 1922

As inflation increases, the volatility of the inflation rate tends to increase. This means that it is harder to place a value on money, thus it becomes more difficult to use it as a store of value.

With a high rate of inflation, the real value of debt erodes. This means that it is effectively easier to pay back the debt. Therefore, in periods of high inflation, banks will be less willing to lend money because they will lose out if people pay back the debt in the future when money is worth less. They will not lend money unless they can charge an interest rate higher than the rate of inflation. If the rate of inflation is stable it is easier to make these calculations.

With high inflation there will be greater Menu costs. This is the cost of changing price lists to reflect the changing value of money.

Does Cutting Taxes cause Inflation?

Does cutting taxes lead to inflation?

Cutting Income Tax

• Reducing income tax will increase disposable income of consumers. Therefore consumer spending and AD will increase. This could cause inflation, if the economy is already quite close to full capacity.
• If economic growth is already low, a cut in income tax is unlikely to cause inflation.
• It also depends on consumer confidence. For example, if consumer confidence is very low, a cut in income tax may not lead to extra spending. People may prefer to save the increase in disposable income. Therefore, inflation will not increase in this case.
• It is possible cutting income tax will increase incentives to work and therefore, in the long run AS may increase. However, I feel this effect is very minor.

Cutting Indirect Taxes like VAT

• If the govt cut VAT, from 17.5% to 15% it would effectively increase the spending power of consumers, therefore, there may be an increase in AD and possibly inflation.
• However, a cut in indirect taxes will also directly reduce the RPI measure of inflation. This is simply because many goods will be cheaper because of the reduction in Tax. However, this will be just a one off reduction in the inflation rate.
• Some measures of inflation therefore ignore the temporary effects of taxes.

The effect of lower taxes depends on Government Spending / Borrowing

• The effect of a reduction in taxes also depends on Government spending.
• If the government cut taxes but also reduce government spending, then the net effect on AD will be neutral and there will be no inflationary affect.
• If the Government cut taxes and increase borrowing it should lead to an increase in AD.
• However, some economists will argue a cut in taxes, financed by borrowing will lead to "crowding out" - Private sector buy more bonds so reduce their income.
• Generally, lower taxes may have an inflationary impact, but the actual effect depends on many variables, such as the ones mentioned here.