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Rising Inflation Essay

Should the government be concerned if the CPI rises to 5%?

Costs of Inflation

The Government set the MPC a target for CPI of 2.% +/-1. It believes inflation higher than 3.0% is potentially damaging to the economy.

  1. Decline in relative competitiveness. If inflation in the UK is higher than elsewhere, then UK goods will become uncompetitive leading to a fall in demand for UK exports. If there is a fall in demand for exports then there may be a deficit on the current account Balance of Payments. However, this may be offset by a devaluation that is likely to occur from high inflation.
    • If the inflation was worldwide caused by an increase in the oil price (e.g. like in 2008), it may be necessary to revise the inflation target of 2% – or at least tolerate a higher inflation rate. The UK would not lose its competitive advantage because every country would have higher inflation. To reduce inflation could cause stagflation (lower growth and higher prices) In other words, it would be more harmful to reduce inflation than to tolerate a temporary spike in inflation.
  1. Depreciation in the exchange rate. If inflation is high there will be a devaluation of the exchange rate, This is something the govt wishes to avoid as it creates uncertainty amongst business and lower purchasing power of Sterling abroad.
  1. Menu costs. Higher rates of inflation may cause menu costs, which means firms have to change price lists quite often. However, this is not that significant when inflation is only 5%. Modern technology has also made it easier for firms to change prices.
  1. Boom and bust economic cycles. If inflation is caused by unsustainable economic growth then the economic boom may be followed by a recession. To reduce inflation and keep inflation within the target, the B of E will have to increase interest rates; this causes problems because AD will fall causing lower growth. For example, in the late 1980s, the UK experienced demand-pull inflation from rapid economic growth – but this led to higher interest rates and the boom turning to bust.
  1. Creates uncertainty. Higher rates of inflation are disliked by business because it makes it more difficult to predict future costs. Therefore investment will be lower. Countries with lower inflation rates generally have poorer economic growth.
  1. A high rate of inflation would make it more difficult to join the Euro because it would breach the Maastricht criteria. If inflation in the UK was higher than Europe a single Monetary policy would be ineffective for the UK. These days, this is not really an issue for the UK as membership of the Euro is very unlikely.
  1. Redistribution. Inflation may cause redistribution of income from savers to borrowers. This is because inflation reduces the value of money. However, this will depend upon the rate of interest. E.g. if the interest rate was 8% and inflation 5%, savers would still have a real interest rate of 3%. However between 2009 – 17, interest rates in many countries were very low (0.5%) and this meant even small amounts of inflation (3-4%) led to a fall in the value of savings.
  1. Real wages It depends on whether wages are keeping up with inflation. If wages are increasing by 2% and inflation is 4% – then real wages would be falling. This happened in the UK between 2009-17.
  2. Hyperinflation. When inflation starts to rise at rapid rates, then inflation quickly becomes very destabilising for the economy. Countries with hyperinflation (Zimbabwe 2000s, Germany 1923) saw an economy devastated by the effects of changing prices. It causes instability and people lose their savings. See: costs of hyperinflation

Is inflation harmful to firms?

Firms would generally prefer low inflation, but also they want economic growth and rising demand.

Costs of Low Inflation / Deflation

Should the govt be concerned with inflation falling below 2.0%?

  1. If prices are falling because AS shifts to the right because of new technology, this is beneficial for the economy, because growth is increasing and jobs should be being created.

  1. If deflation is caused by falling AD then this is a serious economic problem because it indicates a recession with problems such as unemployment, lower output and a negative multiplier effect.
  1. Deflation can cause problems for the economy. It means that those who have debts will see the real value of debts increase, this will lead to lower consumer confidence and possibly lower AD and economic growth.
  1. Deflation makes monetary policy ineffective. This is because interest rates cannot be reduced below 0%.
  1. Companies cannot alter real wages easily because workers are very resistant to any cut in nominal wage wages. Therefore, real wages may rise.
  1. It is more difficult to set prices when there is deflation

Related

How Does Inflation Impact My Life? Impact on You and the Economy

Why President Reagan Said "It's as Violent as a Mugger"

Inflation hurts your buying power. It means you have to pay more for the same goods and services. Inflation can help you if you are a lucky recipient of income inflation. You also might benefit from asset inflation, such as in housing or stocks, if you own an asset before the price rises. 

But if your income doesn’t increase or increases at a slower rate than general inflation, your buying power declines.

Many people get hurt by an asset bubble if they try to time it. Most people buy right when the bubble is about to burst. Overall, inflation reduces your standard of living.

Inflation doesn't affect everything the same way. Gas prices can double while your home loses value. That's what happened during the financial crisis of 2008. There was deflation in home prices, which fell 31.8 percent. 

Meanwhile, inflation occurred in oil prices. They reached an all-time high of $148 a barrel. Since oil prices drive gas prices, the cost of gas rose to $5 a gallon. Driving to work became even more expensive and stressful. That was at a time when many workers were worried about keeping their job. For more, see Inflation and Deflation: Causes and Effects.

The federal government enacted the economic stimulus plan to end the recession. Then the Federal Reserve started quantitative easing. Investors grew worried about inflation.

As a result, they bought gold. The price of gold rose to a record of $1,895 an ounce on September 5, 2011. In this instance, there was inflation in gold and oil prices with deflation in housing prices and personal income.

Inflation has another side effect. Once people start to expect inflation, they will spend now rather than later.

That's because they know prices will be higher later. Consumer spending heats up the economy, creating ever-higher inflation. It's called spiraling inflation because it spirals out of control.

If inflation reaches the double-digits, that's hyperinflation. If it happens, you will need a wheelbarrow of money to buy a loaf of bread. Hyperinflation only happens when the government is so irresponsible that it prints money without regard to the inflation rate. It happened in Germany in the 1920s and in Zimbabwe in the 2000s. If inflation ever approaches the double-digits, your best defense is to buy gold or any currency that isn't pegged to the dollar. For more, see U.S. Economic Collapse.

Effect of Inflation on Retirement Planning

The combination of inflation in some asset classes and deflation in others, makes financial planning more difficult. Rules of thumb no longer apply. One of the reasons government economists didn't do more to head off the recession was because they couldn't believe housing prices would ever fall.

Inflation is really bad for your retirement planning. Your target must keep rising to pay for the same quality of life. In other words, your savings will buy less as time goes on.

As a result, to be prepared for inflation during your retirement, you should save more than you think you will need. 

Impact of Inflation on Treasury Bonds

Inflation is important if you hold bonds or Treasury notes. These fixed income assets pay the same amount each year. As inflation rises faster than the return on these assets, they become less valuable. People rush to sell them, further depreciating their value.  When that happens, the U.S. government is forced to offer higher Treasury yields to sell them at all. This increases most mortgage interest rates.

This lowers the value of your investments. It also increases the cost to the federal government of financing the U.S. debt. It increases the interest on the national debt. The additional budget expense needs to be offset by a cut in the discretionary budget or an increase in taxes.

Otherwise further deficit spending will occur. All of those are contractionary fiscal policies that slow economic growth. That translates into a lower standard of living for you. 

Inflation FAQ

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