Why is Inflation Important?

We all know that nowadays things cost a lot more. This rise in prices is called inflation, but it isn’t a recent phenomenon; even the Roman Empire suffered from rising prices.

What causes inflation?

Inflation is caused by two main factors. First, when too much money is chasing too few goods, demand grows faster than supply and prices rise.

Second, when a company’s costs go up it has to increase prices to maintain its profit margins. Increased costs can be caused by wages, taxes or higher import duties.

Inflation is a sign that an economy is growing, but excessive economic growth can be detrimental as it can lead to hyperinflation as experienced, for example, by Germany in the 1930s and Argentina in the 1980s, when the inflation rate topped 1,000%.

During times of hyperinflation, the value of money rapidly decreases and the cash in your bank account can become almost worthless.

At the other extreme, an economy with no inflation has essentially stagnated. The right level of economic growth, and thus the right level of inflation, is somewhere in the middle.

Interest rates

In the UK, it is the job of the Bank of England to maintain the delicate balance between growth and rising prices. It does this by adjusting interest rates.

In theory, higher interest rates make businesses and consumers reign in spending, while lowering interest rates makes borrowing cheaper, so business can expand and consumers can spend more. So a tightening, or rate increase, attempts to head off future inflation. An easing, or rate decrease, aims to spur on economic growth.

By changing interest rates, the Bank of England tries to achieve maximum employment, stable prices and healthy levels of growth.

Anticipated inflation

Many people think that inflation is bad, but this isn't necessarily so. Inflation affects different people in different ways. And its effects also depend on whether inflation is expected or not.

If the inflation rate corresponds to what the Government is expecting – known as anticipated inflation – then people can compensate and the cost isn't high. For example, workers can negotiate contracts that include automatic wage hikes as prices rise.

Unanticipated inflation

Problems arise when there is unanticipated inflation. Creditors lose and debtors gain if the lender does not anticipate inflation correctly. Unanticipated inflation creates uncertainty about what will happen next in the economy and makes corporations and consumers less likely to spend, hurting economic output in the long run.

People living off a fixed income, such as the retired, see a decline in their purchasing power and, consequently, their standard of living.

If the inflation rate is greater than that of other countries, domestic products also become less competitive, further damaging the economy.

So inflation itself isn’t an issue; as long as wages go up with inflation people will still be able to maintain their standard of living. The question isn’t whether inflation is rising, but whether it's rising at a quicker pace than your salary.