Rising prices have certain beneficial effects for business:
i) Inflation diminishes the real cost of borrowing money. Since firms are usually net borrowers, an inflationary environment redistributes wealth from financial institutions to companies, reducing their net debt.
ii) In a period of rising prices, it is more difficult for workers to maintain their real wage, this leading to a further reduction of real costs.
iii) Rising prices are positive for expectations because firms see the value of their output and their stock increasing over the time.
A more careful analysis of inflation distinguishes between these benefits in the short term and more important costs in the medium and long term. In the long term, individuals have zero money illusion, banks and workers index interest rates and wages to actual inflation so that gains from points i). and ii). are ruled out or can be maintained only if inflation (not prices) is continuously increasing.
But the major costs of inflation relate to the uncertainty and unpredictability that it introduces in the economic system:
i) Inflation is difficult and costly to predict.
ii) Sustained inflation lowers expectations of economic agents.
iii) It shifts resources from productive to speculative investments.
iv) It can create social disruption.
The evidence of the last ten years highlights that the decline in inflation is associated with an improvement in economic efficiency and social stability and this is good, not just for businesses, but also for economic growth.
Q4 Why do monetarists believe that sustained inflation is impossible without the explicit or implicit acquiescence of the monetary authorities?
We have to distinguish between the causes of inflation and causes of sustained inflation. Inflation can have different causes, it can be demand-driven or supply-driven.
Demand-driven inflation is due to shocks in the aggregate demand. These shocks can be caused by optimistic expectations, tax cuts, government deficit or increase in the money supply that exceeds real output growth. In figure 12.1 we can see that all these changes shift the AD curve outwards to AD' having the effect of increasing price level from P0 to P1.
Also supply-shocks can cause inflation, through an increase in the cost of energy (as the two oil crisis of the 1970s show), raw materials (due to sudden shortages) or labour (if trade unions are able to contract an increase in the real wage higher than the increase in productivity). Firms will tend to pass higher costs on higher prices, fuelling in this way the inflationary spiral. Supply-shocks can be represented by movements of the AS curve leftwards to AS', moving the price level from P0 to P2 in figure 12.1. They have also the