Author: Geoff Riley Last updated: Sunday 23 September, 2012 Analysing the Consequences of Inflation
High and volatile inflation has economic and social costs.
When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects. Trade unions might use their bargaining power to negotiate for increases in money wages to protect the real wages of union members. Households may switch savings into accounts offering a higher rate of interest or into other financial assets where capital gains might outstrip price inflation. Businesses can adjust prices and lenders can adjust interest rates. Businesses may also seek to hedge against future price movements by transacting in “forward markets”. For example, many airlines buy their fuel months in advance as a protection or ‘hedge’ against fluctuations in world oil prices. Unanticipated inflation:
When inflation is volatile, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future. Unanticipated inflation occurs when people, businesses and governments make errors in their inflation forecasts. Actual inflation may end up below or above expectations causing losses in real incomes and a redistribution of income and wealth from one group to another Money Illusion
People often confuse nominal and real values because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages – giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income. Money illusion is most likely to occur when inflation is unanticipated, so that people’s expectations of inflation turn out to be some distance from the correct level. The Economic Costs of Inflation
We must be careful to distinguish between different degrees of...
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