Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. Inflation is measured by the Consumer Price Index (CPI) and the Retail Price Index (RPI). The difference between CPI and RPI is that CPI excludes housing costs whereas RPI doesn’t, and also RPI excludes people in the top 4 per cent of earners. Central banks attempt to stop severe inflation along with sever deflation in an attempt to keep the excessive growth of prices to a minimum.
A rising rate of inflation can potentially have beneficial and negative effects on an economy. One possible consequence of a rising rate of inflation is the impact on savers. Inflation leads to a rise in the general price level so that money loses its value. When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if nominal interest rates are lower than inflation – leading to negative real interest rates.
For example, a saver might receive a 3 per cent nominal rate of interest on his/her deposit account, but if the annual rate of inflation is 5 per cent, then the real rate of interest on savings is -2 percent. This means that the people who are receiving a lower nominal rate of interest or annual bonus, then people are actually worse off than they would be if the inflation rate were to be the same or lower than the nominal rate of interest or annual salary bonus. Consequently, consumers lose confidence and this leads to an increase in consumer saving and a decrease in consumer spending.
This has a large effect on the performance of the UK economy as it reduces consumption in an economy, which is the largest component of Aggregate Demand (approximately 60 per cent). Thus, leading to a shift inwards of the AD curve and also effecting long run economic growth. This is similar to the money illusion effect, which is where consumers confuse nominal and real values in their everyday lives because the effects of inflation mislead them. For example, a worker might experience a 6 per cent rise in his money wages, therefore giving the impression that he/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. Another possible consequence of a rising rate of inflation is that it affects the international competitiveness of the UK and also increases unemployment. If inflation in the UK is persistently above its major trading partners (Europe), British exporters may struggle to maintain their share in overseas markets and import penetration into the UK domestic market will grow.
Thus, foreigners decide to stop buying British goods, as this inflation on commodities and capital goods lead to cost-push inflation in production, which will lead to the rise in prices of UK goods and services. This could potentially lead to a worsening of the balance of payments (imports – exports), which is a component of Aggregate Demand and therefore a shift in the AD curve of the UK economy inwards.
This would therefore affect the long-term economic growth of the UK, which is measured by Real GDP, as the productive capacity of the economy decreases along with the Production Possibility Frontier and Short Run Aggregate Supply curve. The productive capacity of the economy decreases because of firms not being able to cope with the cost-push inflation in the economy as workers want higher wages in order to keep real income the same. This therefore leads to firms making employees redundant, which increases the unemployment of the UK economy.