3.2.2
Note

Consequences of Inflation and Deflation

3.2.2 Macro issues

Idea

High inflation and deflation both impose costs, though of different kinds. This note is a neutral catalogue of the effects on each agent for use in evaluation; it reaches no verdict, and the costs of mild, stable inflation are far smaller than those of high inflation or deflation.

Considerations

Consequences of high inflation.

  • Consumers — eroded purchasing power. Inflation erodes the internal value of money, so a given sum buys fewer goods; where nominal income lags inflation, real income falls. Workers may demand higher wages to compensate, prompting firms to raise prices further — a wage–price spiral that, unchecked, can tip into hyperinflation. Lower-income households, who spend more of their income on necessities, are hit hardest, widening income disparity.

  • Allocative inefficiency. Shoe-leather costs are the opportunity cost of the time and effort spent counteracting inflation (moving money to preserve its value); menu costs are the resources firms spend repricing catalogues, tags and listings. Both divert resources from productive use.

  • Producers — discouraged investment. Severe price instability makes the marginal efficiency of investment (MEI) hard to predict, so investment becomes too risky to undertake.

  • Government — slower growth, higher unemployment, worse trade balance. Cost-push inflation can bring stagflation. To contain rising labour costs firms may shed workers, raising unemployment. Domestic inflation also raises export prices relative to trading partners and makes imports relatively cheaper, worsening the balance of trade.

Consequences of deflation.

  • Postponed consumption and investment. Expecting prices to keep falling, consumers delay purchases and firms delay investment, so aggregate demand falls.

  • Reduced profits and a deflationary spiral. Falling demand cuts firms’ revenue and profit, prompting lower output and demand-deficient unemployment. Left unchecked, falling prices, falling incomes and falling spending reinforce one another in a deflationary spiral that lowers both material and non-material living standards.