theory gives a better representation of the situation in the 1980s and 1990s.
Q3 Suppose the UK inflation rate were to rise from 2% to 10%. Indicate three sections of the community that would lose and three that would gain from this. List three reasons why a resurgence of inflation might be bad for the British economy.
Losses will be sustained by:
i) Workers, if their wages are not indexed to inflation.
ii) Categories which payments are fixed in nominal money (pensions, unemployment benefits).
iii) Lenders who set fixed interest rates on their loans because they were not expecting high inflation.
Eventually, these categories will learn from higher inflation and bargain an increase in their payments consistent with the new level of inflation. However, they will suffer a real loss in the short period.
Gains will be shared by:
i) Firms, which will see the real cost of borrowing money reduced.
ii) Other categories, which have borrowed money at a fixed nominal interest rate.
iii) The government, which sees the real cost of its debt reduced (through the 'inflation tax' the government pays part of its debt).
Also for these categories, gains will be maintained only in the short period. The adaptation to higher inflation for all the economic agents will be concluded in the long term, thus implying that these gains will be maintained only if inflation was continuously increasing.
Inflation might be bad for UK economy for the following reasons:
i) Inflation is a sign of instability and weakness in the management of macroeconomic aggregates. It would menace the credibility of the Central Bank in attaining its institutional goal of price stability and fuel speculations of further and higher inflation, thus disrupting the functioning of the markets. Speculation could arise in financial markets (productive investments would by replaced by speculative investments) and in the currency market, leading to a devaluation.
ii) The government will be punished by the financial markets. Inflation will be seen as a way to finance the public debt and would arouse fears over the sustainability of the debt. Therefore, interest rates on government bonds will grow to compensate for the higher risk. Eventually, this will further endanger government's target of fiscal policy.