iii) Substitution bias: this refers to the change in relative prices. Consumers tend to substitute away from more expensive to cheaper goods and from more expensive to cheaper retail outlets (outlet bias). If the statistics fail to register this shift, inflation results overestimated.
Errors in inflation estimates can affect the economic system in several ways: first, monetary policy management would be biased and, depending on the economic authorities' goals, the result would be further increase of inflation (if they decide to accommodate it) or deflationary and recessive policies (if they perceive inflation as too high). Second, payments linked to inflation (pensions, social welfare payments and, in some case also wages) can modify their real purchasing power, thus affecting real variables.
Q2 Discuss the reasons why one might expect, over the long run, countries with lower inflation to enjoy faster growth than those with higher inflation?
The relationship between inflation and growth is not easy to determine. Multi-country studies highlight that low inflation is associated with high growth and hyper-inflation is associated with economic decline; but the evidence is less clear for countries in between. Growth has multiple causes and inflation is only one factor entering in its determination; yet, the costs for growth associated with inflation emerge clearly when we consider the long run: inflation is a threat to efficient allocation, fair distribution and trust in the economic authorities.
i) The price-adjustment mechanism cannot work efficiently. With persistent and high inflation, economic agents suffer a certain degree of money illusion and the price system functions less efficiently in adjusting demand and supply.
ii) Inflation changes the composition of investment. It induces savers to invest in unproductive 'inflation hedges' (real estates, foreign currency deposits) rather than in more socially productive assets, fuelling speculation. Thus, inflation impacts negatively on the capacity of the society to generate wealth, by causing the misuse of capital and by distorting the behaviour of entrepreneurs.
iii) Inflation redistributes wealth among categories of citizens. It helps borrowers in reducing the real cost of borrowing and hits lenders. It redistributes money from those whose incomes are fixed in nominal money terms to those whose incomes are inflation-indexed. This can cause major social tensions and, in case of hyper-inflation, also threaten democratic institutions.
iv) Inflation is self-reinforcing and once started it is difficult and costly to reduce.
v) Persistent inflation could reduce the attractiveness of a country to foreign investment and consequently it diminishes growth possibilities.
Q3 It is sometimes said that business tends to be soft on inflation because firms prefer an environment of rising prices to one of static or declining prices. Do you agree?