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Unit 4 Inflation and unemployment

4.3 What’s wrong with inflation?

There are three answers to this question.

  • Inflation matters when it affects real incomes. There are winners and losers from inflation, depending on what people consume; the source of their income (wages, profits, or transfers, for example); how quickly wages, benefits, and interest rates adjust to price increases; and whether a household is a net lender or borrower.
  • Moreover, inflation is costly even to those whose real incomes increase, because it makes future prices uncertain, exposing people to risks, which make them feel worse off.
  • However, a constant little bit of inflation can be a good thing.

Inflation alters the distribution of real income, possibly in undesirable ways

A shift in inflation from 2% to, say, 8% creates winners and losers. This happens through three main channels:

New evidence strongly supports this explanation of why people dislike inflation: ‘The predominant reason for people’s aversion to inflation is the widespread belief that it diminishes their buying power, as neither personal nor general wage increases seem to match the pace of rising prices.’1

real wage
The wage expressed in terms of the amount of goods and services the worker can buy with it. It is calculated by dividing the nominal wage by the current price level in the same currency. See also: nominal wage.
nominal wage
The actual amount received in payment for work, per unit of time, expressed in a particular currency. Also known as: money wage. See also: real wage.
nominal interest rate
An interest rate is nominal if it is not corrected for inflation. The rates quoted by high-street banks on loans and savings accounts are nominal interest rates. See also: interest rate, rate of interest, real interest rate.

  1. Wages are set periodically—usually annually. Firms normally adjust their prices following the ‘wage-setting round’. In an inflationary environment, this means the real wage, that is, what can be purchased with the nominal wage, often falls (as shown in Figures 1.9 and 1.10). Workers are the losers.

  2. Some people are net debtors, which means they owe more money than is owed to them, and some are the opposite. A household with a mortgage is a borrower with debt and may also be a lender with a savings account. The interest rate set by a bank on a mortgage or savings account is a nominal interest rate, which means that it is not changed when inflation changes. The amount that you pay or receive in interest is fixed in money terms. Then, if you are a net debtor, an increase in inflation is good because it reduces the burden of debt repayments. Conversely, if you are a net lender you lose from inflation because the fixed nominal repayments you get buy less in goods and services.
    There are large differences across countries in this regard. For example, home owners in the UK are able to fix the nominal interest rate on their mortgage for only a few years whereas in the US, the norm is for a 30-year ‘fix’. Unit 5 addresses the question of why the central bank is likely to respond to rising inflation by raising the nominal interest rate. This would increase the monthly repayments on a variable rate mortgage, offsetting the gain to the borrower. Additionally, if borrowers’ wages take longer to increase following inflation than for the interest rate to rise and increase their debt repayments, this can create short-term liquidity issues for borrowers. And unless the bank passes on the increase in the central bank’s policy interest rate to savers, they may still lose from inflation. For estimates of the effect of inflation in redistributing wealth in 2022, visit the St. Louis Federal Reserve website.

Very high inflation will wipe out the value of nominal assets, which happened in Zimbabwe in 2008–2009.2

  1. Poorer and richer households consume different baskets of goods. In an inflationary episode, prices may rise most for the basket consumed by lower-income households. A European Central Bank publication shows that households in the lowest-income quintile group in the euro area experienced an ‘effective inflation rate’ two percentage points higher in September 2022 than the highest quintile group, due to having a higher budget share spent on electricity, gas, and food. Young, middle-aged, and older (retiree) households also experience inflation differently mainly because older households rely more on income that is fixed in nominal terms.

Inflation creates uncertainty about future prices

Prices convey information that guides resource allocation—a high price, relative to other prices, suggests resources should be directed to producing more of that good or service. If prices are rising for most goods and services in the economy, firms might find it harder to know which sector to invest in, or which crop would be better to plant (quinoa or barley, for example); and individuals would find it harder to decide whether quinoa has become more expensive relative to other sources of protein. When inflation is high, it tends to be volatile, which increases the uncertainty. With higher uncertainty about future prices, comes additional risk in making decisions, which reduces peoples’ well-being.

menu costs
The resources used in setting and changing prices.

In an inflationary environment, firms have to update their prices more frequently than they would prefer. As the cover image for this unit suggests, this requires time and resources (for example, physically changing price labels in shops), referred to as menu costs. Effort is also spent by households and firms engaging in transactions because of inflation, for example having to review more often where they are holding their savings.

Although these transactions are now done online, the costs are still referred to as shoe-leather costs in reference to the additional wear on people’s shoes as they walk to the bank more often.

A little bit of (predictable) inflation can be a good thing

Many economists think that a low but positive rate of inflation is a good thing, as long as it remains stable. As we will discuss in Unit 5, one reason to prefer some inflation to none is that it gives the central bank more scope for using monetary policy to cut the interest rate and stabilize falling aggregate demand.

A second reason is that the process of innovation and change that characterizes a dynamic economy means that in any given year, workers in some firms and sectors will be more in demand than in others. This means that some wages will need to go up relative to others. In principle, the necessary change in relative wages can be achieved by a cut in the nominal wage offered for less-in-demand jobs or by an increase in the wage for jobs for which demand is increasing. But cuts in nominal wages are unpopular.

And they may be unnecessary if there is some inflation ‘to grease the wheels of the labour market’. With rising prices, a fall in real wages among the losers may be masked by the fact that nominal wages are rising, or at least not falling. For example, many people will not even notice a slight fall in their real wage due to modest inflation, but nobody would fail to notice a reduction in their nominal wage. With some low inflation, the required adjustment of workers and resources between different firms and industries in response to changes in relative wages can take place more smoothly without losers experiencing falling nominal wages.

Deflation

Would households and firms be better off with falling prices (deflation)? No. A sustained fall in the price level is undesirable for many of the same reasons that inflation is undesirable. And there are other problems as well.

When prices are falling, households will postpone consumption (particularly of expensive items such as fridges, screens, and cars) because they expect goods will be cheaper in the future. We will learn later in the unit that a prolonged recession caused by weak aggregate demand is a likely cause of deflation. This would be exacerbated if spending decisions are postponed.

zero lower bound
This refers to the fact that the nominal interest rate cannot be negative, thereby setting a floor on the nominal interest rate that can be set by the central bank at zero. See also: quantitative easing.

As we will discuss in Unit 5, whereas the central bank has a tool—raising the policy interest rate—to dampen inflation, it hits a floor when trying to use the interest rate to prevent prices falling. It cannot reduce the nominal interest rate below zero. This is called the zero lower bound, ZLB.

The problems with deflation

Japan is a case study in the problems of deflation. The Japanese economy was one of the great success stories of the period after the Second World War, as shown in Section 1.2 of the Microeconomics volume.

Living standards, as measured by GDP per capita, went from less than one-fifth of the level in the US in 1950 to more than 70% by 1980. But since the 1990s, Japan has experienced low growth and rising, although still low, unemployment (Figure 2.27). For the first time for a high income economy in the postwar period, there has been persistent deflation: deflation was observed in 15 years out of 28 between 1995 and 2022. Inflation in Japan in 2022 was not as high as other G7 economies, partly due to government price controls and a slower economic recovery from COVID-19. A shift to sustained low but positive inflation could have beneficial effects in Japan, like creating a more efficient labour market—as we will learn below.

Question 4.2 Choose the correct answer(s)

The following table shows the annual inflation rate (the GDP deflator) of Egypt, Fiji, Portugal, and Tonga in the period 2018–2021:

2018 2019 2020 2021
Egypt 21.2% 13.6% 6.2% 4.8%
Fiji 1.4% 2.2% −1.2% −3.4%
Portugal 1.8% 1.7% 2% 1.5%
Tonga 5.1% 7.7% −4.2% −1.9%

Based on this information, read the following statements and choose the correct option(s).

  • Tonga experienced disinflation between 2020 and 2021.
  • In Portugal, the price level was not more than 2% higher in 2021 than it was in 2018.
  • Egypt experienced deflation between 2018 and 2021.
  • Fiji’s price level at the end of 2021 is lower than it was at the start of 2018.
  • Disinflation describes a falling inflation rate. Tonga experienced deflation between 2020 and 2021 (the price level declined over the two-year period) but the rate at which prices were falling declined: there was less deflation in 2021 than in 2020.
  • Although the annual inflation rate over those years did not rise above 2%, the cumulative effect of the annual increases left the price level 7.2% higher in 2021 than in 2018. The price level at the end of 2021 is \((1 + 0.018) \times (1 + 0.017) \times (1 + 0.02) \times (1 + 0.015) = 1.072\) of that at the start of 2018, that is, an increase of 7.2%.
  • Egypt experienced disinflation (a falling inflation rate), not deflation (a falling price level).
  • The price level at the end of 2021 is \((1 + 0.014) \times (1 + 0.022) \times (1 − 0.012) \times (1 − 0.034) = 0.989\) of that at the start of 2018, that is, a fall of 1.1%.

Exercise 4.4 Comparing values over time

When making comparisons between different time periods for values expressed in money terms, such as costs, prices, or wages, it is important to adjust for inflation so that accurate comparisons can be made. To do this, you can use the following formula:

\[\text{price in today’s dollars} = \text{price in earlier time} \times \frac{\text{price level today}}{\text{price level in earlier time}}\]

When the minimum wage was introduced in the US in 1938, it was set at $0.25 in 1938 dollars. For 2022’s price level, we can use the CPI for 2022 (292.7) and for the price level in 1938, we can use the CPI in 1938 (14.1).

  1. How much would the $0.25 minimum wage introduced in 1938 be worth in 2022 dollars?

You can also rearrange the equation to calculate how much current values would have been worth in earlier times. The US federal minimum wage in 2022 was $7.25.

  1. How much would the federal minimum wage in 2022 be equal to in 1938 dollars?

  1. Stefanie Stantcheva. 2024. ‘Why do we dislike inflation?’ Brooking Papers on Economic Activity BPEA Conference Draft, March 28-29, p. 1. ↩

  2. The Economist. Updated 27 April 2013 ‘In Dollars They Trust’. ↩