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Business & Inflation

Inflation

Inflation is a persistent rise in the general price level. It is a persistent increase in the Retail Price Index (RPI) measured on a year by year basis.

The Retail Price Index is a weighted average of the prices of goods and services — the index is weighted in the proportion to which an average household consumes these goods and services.

Causes of Inflation

The causes of inflation are

1		A demand side “shock”. Too much demand in the economy. When demand exceeds supply in the economy the price of goods can increase rapidly. This is inflation.
2		A supply side “shock”. When owing to a war or other catastrophe there is a reduction in supply, this causes an increase in prices.

Once inflation has been set in motion, inflation can become endemic in an economy owing to:

1		Cost push inflation. The increase in inflation causes an increase in wage demands. If these cannot be resisted there is an increase in wage costs. Suppliers seek to pass these wage costs onto the consumer, resulting in increased prices. Since wage demands are in excess of headline inflation figures, the result can be mounting inflation as costs push up ahead of prices, so prices must be pushed up head of costs!
2		Monetary validation. The government allows money supply to increase in line with the increase in prices. This allows the situation of “too much money pursuing too few goods” to persist, resulting in further inflation.

Negative effects of inflation

The main negative effects of inflation are

1		It redistributes income from people on fixed incomes (that do not rise with inflation) to people on variable incomes (that do rise with inflation). Since most people with fixed incomes are poor (for example, receive social benefits that do not rise in line with inflation), and people with variable incomes are relatively richer, the effect of income is to redistribute income from the poor to the rich.
2		Inflation erodes international competitiveness. Exports cost more abroad. This can cause a decrease in demand for exports. That in turn can lead to a decrease in demand for the currency and to a devaluation of the currency. The devaluation may restore exports, but at the cost of making imports more expensive, thus increasing inflation again!

It is because inflation erodes international competitiveness that most governments make controlling inflation the central pillar of their economic policy.

Impact on businesses

Inflation has the effect of redistributing purchasing power. Some groups in society gain from inflation, eg. Debtors. Others lose: savers, creditors, those on fixed incomes, those in non-union trade. Businesses may suffer if their customers experience a decline in their real incomes. If inflation is one of costs rather than prices, profit margins will shrink. On the other hand, inflation caused by excess demand may lead to an increase in profit margins.

The most damaging aspect of inflation from the business point of view is that it makes planning for the future difficult. Assessing future investment projects is made more complicated by uncertainty about future prices. Making provision for the replacement of equipment as it wears out is more difficult when the replacement cost is higher than the historic cost.

Inflation also raises the tax burden since some taxes are directly related to income and the value of spending. Cost of living pay rises will raise the amount of income tax paid by the individual, as well as the proportion of income paid in tax.

Controlling inflation

Governments seek to control inflation mainly by increasing interest rates to dampen demand in the economy. This is called monetary policy, since its effect is to control the growth of the supply of money in the economy.

In the past governments tried other policies such as controls on lending, and a prices and incomes policy — government imposed restrictions on wage increases either imposed by means of legislation, or negotiated with representatives of labour (the unions). However, these policies have proven to be ineffective in the past, and the main policy instrument to control inflation is the setting of the bank base rate — the control of the interest rate.

Raising interest rates dampens demand and reduces money supply for the following reasons.

Interest rates are the cost of borrowing money. Therefore, when interest rates rise, the cost of borrowing both for consumers and business rises. Since it costs more to borrow for consumer purchases, this causes consumers to reduce their demand for goods and services. Since businesses have to pay more for borrowed capital, they invest less, which also reduces demand. Also, some businesses may be forced out of business (liquidation) as a result of the increase in the cost of their interest payments, thus creating unemployment, which also reduces demand.

There is another link between interest rates and demand in the economy — that is, via the housing market. There is evidence that the housing market is strongly linked to consumer expenditure. When house prices are rising, people can remortgage their properties and use the cash obtained to fund consumer purchases. When interest rates go up, the cost of borrowing for a house purchase increases, thus reducing demand for houses, and causing a downturn in house prices. This dampens confidence and consumer expenditure.

So all in all, raising interest rates results in (a) a reduction of inflation (after some time), and (b) a great deal of misery for consumers and especially businesses (almost immediately).