With inflation, households and firms will have to search for good returns from their savings to protect their real earnings. This involves extra costs called “shoe leather” costs. Furthermore, menu costs are also an example. It is the cost of changing the prices in publicity material, displays, and slot machines.
Inflation leads to negative effects on growth. An increase in interest rates will have a negative effect on investment and output both of which will adversely affect the employment rates. Monetarist economists are quick to point to this particular effect of inflation.
Labour unrest is also a consequence of inflation. This may occur if workers do not feel that their wages and salaries are keeping up with inflation. It may lead to disputes between unions and management.
If a country has a higher rate of inflation than that of its trading partners, then this will make its exports less competitive, and will make imports from lower-inflation trading partners more attractive. This may lead to fewer export revenues and greater expenditure on imports, thus worsening the trade balance. It might lead to unemployment in export industries and in industries that compete with imports.
Finally, inflation is strongly linked to the exchange rate. Therefore, when domestic inflation is higher than in countries with which trade is done, there is a tendency for the value of the domestic currency to fall.
On the other hand, deflation is when the price level falls during a time period. We as consumers might be pleased to face falling prices. However, a significant number of problems can be associated with the fall in the price level.
The biggest problem associated with deflation is unemployment. As aggregative demand decreases, firms are likely to lay off workers. This may then lead to deflationary spiral. If prices are falling, consumers will try to reduce their expenditure as they want to wait until the prices drop even further. This is called deferred consumption. This will lead into a further decrease in aggregative demand.
During deflation, firms confidence is likely to be low, and this is likely to result in reduced investment. This has negative implications for future economic growth.
Moreover, if profits are low, this may make too difficult for firms to pay back their loans and there may be many bankruptcies. This will further worsen the business confidence.
B
The appropriate policies to reduce the rate of inflation depend on the type and the cause of inflation. Knowing that demand-pull inflation is due to an increase in aggregative demand, then the suitable policy would be to decrease the aggregative demand. An example of policies that the government could use is deflationary fiscal policy. This states that; to cure inflation you must increase taxes and lower the government expenditure. Deflationary monetary policy is a second policy that the government could use. This states that you must raise interest rates and reduce the money supply.
However, each of the policies has some problems. First of all, from a political standpoint, such policies are highly unpopular. People are unlikely to accept high taxes that reduce deposable income and the level of consumption. A reduce in the government expenditure may not satisfy a lot of groups in the economy. If government expenditure is reduced, their will be less merit and public goods which means less hospitals, schools, roads,…etc and this may result in less support for the government. High interest rates will also harm some people in the economy, most obviously anybody who has taken a loan or mortgage. High interest rates mean higher loans and mortgage repayments and will therefore be unpopular. A government that wants to be re-elected will hesitate to use these methods to fight inflation.
In some countries where central banks are independent they use such policies. Because it is not going to be elections and its goals are always for the long run. That is, as long as people have faith in the central bank’s ability to contain inflation, then they will not expect higher rates of inflation. If they do not expect high rates of inflation, then they will not make demands for increases in wages any higher than the expected and this will keep the cost of labour from rising excessively.
Nowadays, monetary policy is considered to be the most successful way of controlling aggregative demand in the economy and changes in interest rates is considered as that the best weapon in the fight against inflation. Fiscal policy is not seen as effective as the monetary one. Because it would be very difficult for the government to reduce their spending, because of their commitments to the public. Moreover, it takes a lot of time to have any effect on the price level.
If inflation is caused by a cost-push reason then deflationary demand-side policies may bring down the price level, but they will result in lower national output and are likely to cause unemployment to rise. Therefore, supply-side policies are used instead of demand-side policies. However, it is difficult to distinguish the demand-pull from the cost-push factors, and so policy-makers are likely to use a mix of solutions.
