Inflation » The Impact of Inflation

Prices and wages

The most obvious effect of inflation is on prices. When the general price level rises, each pound buys fewer goods and services. Economists say the purchasing power of money falls. Someone saving cash under the bed finds that it buys less each year. People on fixed incomes, such as some pensioners, are hit hardest because their income does not rise to match prices.

Inflation also affects wages, but you must be careful. A pay rise only helps if it is bigger than inflation.

Key terms:

• Purchasing power: the amount of goods and services that money can buy.
• Nominal wages: wages measured in money, with no allowance for price changes.
• Real wages: wages adjusted for inflation. They show what the wages can actually buy.

If nominal wages rise by more than inflation, real wages rise. If they rise by less, real wages fall. Workers whose real wages are falling often ask for bigger pay rises. If firms agree, their costs go up, which can push prices up again (see Causes of Inflation and Interest Rates).

Exports and unemployment

Suppose prices rise faster in one country than in its rivals. Its goods become dearer compared with goods from abroad. Foreign buyers switch to cheaper rivals, so the country's exports fall. At home, people may also buy cheaper imports instead.

Falling sales can lead firms to cut output and workers. This is one way inflation can raise unemployment. Inflation can also lead to unemployment if the central bank raises interest rates to bring it down, because higher borrowing costs reduce spending and firms may cut staff. How governments weigh inflation against other objectives is covered in Trade-Offs Between Objectives.

Costs to firms and households

Inflation also creates costs that are easy to forget. Two of them have odd names.

Key terms:

• Menu costs: the costs to a firm of changing its prices, such as reprinting menus and price lists, relabelling goods and updating websites.
• Shoe leather costs: the time and effort people spend looking for the best prices, or moving money around, to protect its value during inflation.

Uncertainty, confidence and investment

High inflation is hard to predict. When prices keep changing, people do not know what things will cost next year. This is uncertainty.

• Business confidence: a firm that cannot predict its costs or the price it can charge finds it hard to plan, so it may feel less sure about the future.
• Consumer confidence: households worried about rising prices may spend less and save more, or put off big purchases.
• Investment: spending by firms on capital goods, such as machines and buildings, to make more in future. Uncertainty, falling confidence and higher interest rates make firms less willing to invest. Lower investment can reduce future growth.

Key terms:

• Uncertainty: not knowing what will happen in future, such as what prices will be.
• Business and consumer confidence: how positive firms and households feel about the economy.
• Investment: spending by firms on capital goods to produce more in future.

Summary table

Area	Effect of high inflation
Prices	Money buys less
Wages	Real wages fall if pay rises are smaller than inflation
Exports	Dearer goods, so fewer sold abroad
Unemployment	Lower sales and higher interest rates can cost jobs
Menu and shoe leather costs	Time and money wasted
Confidence and investment	More uncertainty, less confidence, less investment

Exam-style question

In Country Veshna, the prices of goods have risen by 6% in a year, which is faster than in its main trading partners. Average nominal wages rose by 4%. Many cafes have had to change their prices three times this year.

(a) Define 'real wages'. [2 marks]

(b) Calculate the approximate change in real wages in Country Veshna. [2 marks]

(c) Explain two ways high inflation could harm firms in Country Veshna. [4 marks]

Recap

• Inflation reduces purchasing power.
• Real wages fall when nominal wages rise by less than inflation.
• Dearer goods can reduce exports and cost jobs.
• Menu costs are the cost of changing prices. Shoe leather costs are the time and effort spent protecting money.
• Uncertainty lowers confidence and investment.