Inflation
Welcome to this section on inflation! We will explore various aspects of inflation, including its definition, measurement, causes, effects, recent trends, and how policy makers tackle it. So, let's dive into the world of inflation and monetary policy!The SQA Higher Economics specification for this section
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The Effects of Inflation on Households
Decreasing Purchasing Power
Inflation decreases the value of money by reducing its purchasing power. For example, if the prices of food items rise by 5% over a year, a person can buy fewer items with the same amount of money. This is referred to as a decrease in the purchasing power of the consumer, which increases the cost of living for consumers. The cost of living refers to the costs of everyday essentials such as utilities, fuel, and food, rises with inflation. This increase makes individuals worse off as rising costs decreases disposable income available.
Wage and Income Changes
Wage and income values decrease during periods of inflation. While some employers offer wage increases during periods of inflation, these increases often don't match the inflation rate, causing a real decrease in the value of wages. For example, between September and November 2022, the Office for National Statistics (ONS) reported that average wages rose by 6.4%. However, inflation grew by 10.7% in the same period. Use the below calculator to find out what pay rise you would need to receive if you were earning £40,000, £50,000 etc.
Saving and Investment Behaviour
Inflation can change the behaviour of individuals regarding investments:
- Property Investment: With high inflation, house prices may increase beyond the purchasing power of the consumer. As a result, individuals may postpone plans to purchase housing as deposits grow. A 1 bed valued at £150,000 will require a £15,000 deposit, which is a higher burden when inflation is high.
- Luxury Purchases: As disposable income decreases due to a rise in the cost of living, individuals may reduce spending on luxury goods, affecting sectors like travel and hospitality. However, recent demand for travel and tourism has not decreased due to ‘revenge spending’ on travel following the lifting of Covid-19 restrictions.
- Savings and Investment: Inflation reduces the value of savings and investments, making them less attractive to individual consumers. For example, if the saving rate is 4% while inflation is 10%, this is a 6% decrease in the real value of your savings.
Borrowers vs Lenders
Inflation can benefit borrowers as they repay loans with money that has a lower value. However, lenders may suffer as the real value of the loan repayment decreases due to rising inflation.
The Fraser of Allander Institute regularly explores the effects of inflation on consumer and firm behaviour in the economy:
The Effects of Inflation on Firms
Increased Input Costs and Decreased Profitability
A rise in inflation leads to higher costs of inputs, or raw materials. An increase in these costs, along with rising labour costs and operating expenses, can decrease a firm's overall profitability. If food inflation is 20%, then the costs of inputs for restaurants will increase significantly. As a result, firms may need to raise prices or risk significantly reduced profits.
A sharp rise in food and energy prices have threatened the profits of restaurants of late. The cost of living crisis has additionally led to a downturn in bookings in the industry due to consumer constraints. As a result, the hospitality industry has suffered significant losses.
Consumer Demand Shifts
Input cost however is not the only factor that impacts businesses as a result of a rise in inflation. Changes in consumer demand can also impact firms due to inflation. For instance, as disposable income decreases, the demand for luxury goods, such as holidays, may decline, negatively affecting firms in these sectors.
Labour Availability
With rising inflation, employees may demand higher wages to keep pace with the increase in the cost of living. This demand can lead to higher wage costs for businesses and potentially increase the likelihood of strike action.
Planning and Investment
Similarly to individuals, a rise in inflation can create uncertainty for firms and impact investment and planning decisions. If inflation rates are high, firms may choose to postpone investment and reduce costs.
This report from the FAI demonstrates clearly the impact that the recent rise in inflation has had upon Scottish businesses. It illustrates how businesses might respond to a rise in prices, and why they respond the way they do.
The effects of inflation on different groups
Group | Effect of Inflation | Effect of Deflation |
Borrowers | Benefit as the real value of debt decreases | Disadvantaged as the real value of debt increases |
Savers | Lose out as the value of savings decreases | Benefit as the value of savings increases |
Importers | As inflation rises, we typically buy more imports as goods are cheaper. However, over time, the price of imported goods will increase, decreasing profit margins. | Benefit as cost of importing goods decreases due to strong currency |
Exporters | Disadvantaged as their goods become more expensive for foreign buyers | Benefit as their goods become cheaper for foreign buyers |
Government | Debt burden decreases | Debt burden increases |
People on Fixed Incomes | Lose purchasing power as cost of living increases | Gain purchasing power as cost of living decreases |
Pensioners | Lose if their pension is not inflation-proof | May gain if their pensions are fixed and living costs decrease |
Consumers | Buying power decreases as prices increase | Buying power increases as prices decrease |
Effect of high inflation
Too much inflation can lead to uncertainty in the economy, possibly leading to less investment and higher unemployment. If the inflation rate is higher in the UK compared to other countries such as the USA and France, it could lead to a depreciation of the pound, which could affect the balance of trade.
The Wage Price Spiral: The Bank of England governor, Andrew Bailey, has stated that the United Kingdom is facing a ‘wage-price spiral’ (Financial Times). This situation is dangerous for the economy because it can cause inflation to spiral out of control.
A wage price spiral can occur in a situation where in response to rising prices, workers lobby their employers, often through striking or pay negotiations, to increase their wages. If lobbying is to be successful and lead to a rise in wages, firms respond to higher labour costs by raising their prices even higher in line with the wage increase. As firms rise prices in response, the value of consumers’ money further decreases and they may demand further wage rises. This creates the wage price spiral.
Effect of deflation
Deflation is a decrease in the general price level of goods and services. It occurs when the inflation rate falls below 0%. While it might seem like a good thing because your money can buy more, it's actually a sign of economic distress. This is because deflation discourages spending and investment, which are key drivers of economic growth.
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The deflationary spiral played a significant role in the Great Depression of the 1930s. As prices dropped, businesses reduced production, leading to layoffs and wage cuts, which in turn reduced demand and led to further price decreases. This vicious cycle resulted in a prolonged period of economic downturn.
Deflationary Spiral: a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price.