Discuss the idea that if the economyis to prosper in the long run, the control of inflation should be the mainobjective of Government

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Discuss the idea that if the economy is to prosper in the long run, the control of inflation should be the main objective of Government.

Since Edward Heath spoke about inflation in 1973 it has been a generally held view that the conquest of inflation is the most important task for government economic policy. Whilst this view is beginning to be challenged in all political parties, the public universally regard inflation as having a detrimental affect on the economy.

The problems caused by inflation can depend on whether the inflation is anticipated or not. If everybody knows that inflation is going to be 10% this year, and it is, then firms and consumers can plan for this. Although such planning does not eliminate the costs of inflation completely, it does mean that the rates may be more moderate.

The result of a higher rate if inflation, which is fully anticipated, is to raise the nominal (or market) rate of interest by the increase in the rate of inflation. In the long run this implies that the nominal rate of interest will be equal to the real rate of interest plus the rate of inflation. Thus, if inflation is higher in the UK than it is abroad, the nominal rate of interest will be higher in the UK. This is likely to attract mobile capital funds into the UK. With a floating exchange rate, the inflow of funds will lead to an appreciation of the sterling exchange rate, which may have adverse consequences for the balance of payments.

Even if inflation is perfectly anticipated, people will still be encouraged to reduce their holdings of cash and to keep as much of their wealth as possible in the form of assets whose value rises at least as rapidly as the general price level and which therefore do not decline in real terms. The reduction in the holding of cash balances imposes costs on individuals and firms that they would not have to face if prices were stable. Economising on cash balances requires time and effort. For example, individuals have to make more visits to the bank and other financial institutions to withdraw money. This has been termed the ‘shoe leather’ effect of inflation. In general, there is also a loss of convenience associated with the holding of a liquid asset. These costs could, of course, be avoided if interest were paid on cash balances at the same rate as the rate of inflation.

An economy facing inflation, even if it is fully anticipated, will be required to frequently change nominal values in order to keep the structure of relative values unchanged over time. For example, it is necessary to change the nominal value of prices, wages and tax benefits. These transaction costs may be significant. It is necessary to change the price tags, for instance. It is also necessary to disseminate information of wage and price changes to interested parties. Both of these examples take time, effort and money. The effects of this will be hugely significant to a large supermarket chain that would have to alter their prices in order to accommodate the cost increase incurred by inflation.

The costs of anticipated inflation do not appear to warrant the importance that Governments have attached to the reduction of inflation. Indeed there are no major problems associated with inflation once it is assumed that it is perfectly anticipated and that all groups can take action to protect themselves from its effects. This suggests that the costs Governments seek to avoid by reducing inflation must be those caused by unanticipated inflation.

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If inflation is unanticipated, the actual rate if inflation is different from the expected rate. Unanticipated inflation, and the associated uncertainty about the future level of prices, has effects that are of an entirely different kind and are almost always much greater than those of anticipated inflation.

The effect of inflation on unemployment is relatively strong. If inflation in the UK is greater than it is abroad, then domestic producers will lose price competitiveness at home and abroad if the exchange rate does not adjust sufficiently to correct the inflation differential. The profitability of domestic will be impaired which will ...

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