The current UK inflation rate is 2.7 percent. So what does this mean? The term inflation refers to a general rise in the price of a goods and services. This means the price of a basket of goods this year are, on average, 2.7 percent more expensive than last year.
Costs of Inflation
Most countries adopt a inflation targeting policy; for example, the Bank of England targets the inflation rate at 2 percent.
Generally, governments prefer inflation so they can repay their debts with money that is worth less. If they had their way they would inflate their debts away at a much higher rate than 2%. So why is high inflation deemed a bad thing?
Inflation as we’ve seen helps debtors like governments, but hurts consumers, producers and paper asset holders.
How does the Costs of Inflation affect Businesses?
Constantly increasing prices leads to ‘menu costs’, where companies will have to spend money changing and reprinting their prices. But worse than that, it also leads to uncertainty, making planning of production difficult. Prices need to be raised and this infuriates consumers who blame producers for increasing prices. So businesses try to keep from raising prices. This squeezes profit margins and can cause companies to produce products that sell for less in real terms than they cost to produce. This of course is a recipe for bankruptcy in the long run.
For the general consumer, shopping round for the best price might not seem like a daunting task, but for a business who buys in large volumes, a slight change in prices can have important implications. They prefer to lock in prices under long term contracts this will hurt the supplier (but help the buyer) but eventually suppliers will refuse long term contracts.
As individuals, we may get slightly annoyed every time a company decides increases their prices; but on the other hand, it is a hassle for the company to have to change their prices by printing in price tags, updating all of their systems, etc. Inflation also disrupts business planning. Companies who wish to plan ahead may find it difficult in the presence of uncertainty. They may have problems with budgeting as they are unsure about their costs.
If the inflation rate is high, employees demand higher wages from employers to afford their ‘basket of goods‘. This adds pressure onto employers whose costs have now increased and will then raise prices to maintain their profit margin. Then the whole cycle starts again. There is a term economists use to describe inflation that occurs from firms experiencing a rise in their production costs and consequently increase prices to protect their profit markets, this is cost-push inflation.
Inflation and the Cost of Borrowing
Consider two cases, in one economy, a bank offers a 20 percent interest rate on savings, meanwhile in the second economy, the interest rate is a mere 4 percent. But,the inflation rate in the first economy is 18 percent and in the second economy it is 2 percent. The “real” interest rate in both situations is 2%. This is because, the interest rate offered by the banks are nominal interest rates, which does not take inflation into account. In simple terms, the real rate of interest is given by the nominal interest rate minus the inflation rate. Thus in both economies, the real interest rate is 2 percent; implying that the rate of return in both economies are the same despite the vast differences in (nominal) interest rates. However, as interest rates rise so does the cost of doing business because if you are borrowing today at 18% you have to be sure that you will be able to generate at least 18% profit (including inflation) just to break even. This adds additional uncertainty.
On the other hand, high inflation and the idea that you will be able to pay off your debts with cheaper money may encourage businesses to make unsound investments and expand in areas that they normally wouldn’t. Often high inflation rates inadvertently turn normally conservative businessmen into wild speculators either based on the cost of doing their normal business or in relation to stock prices or currency fluctuations.
Normally, businesses decide to borrow if they can reasonably expect to make a profit. Thus if they can borrow money at 4% and somehow do business with that money that will yield 8% they can repay the bank’s 4% and have a 4% profit. If there is hidden inflation it may appear that they are earning 8% but if inflation is actually 4% and it isn’t factored into the calculation all the profit just vanished. And in a multi-year project a company can begin a project under low inflation conditions and then if inflation heats up it can wipe out the entire project or even cause the company to go under.
Costs of Inflation on Businesses Who Trade Abroad
Inflation does not only erode the value of money, it also affects the value of a currency relative to other currencies. Therefore inflation is particularly important for companies who pursue an export-led growth model. This is where a company gains the majority of its revenue from selling abroad. If a company exported abroad, and the UK had a higher inflation rate than the foreign company, the price of the UK good will rise faster than the other country’s prices, thereby making the UK goods less attractive to the foreign consumer.
Thus, inflation isn’t only about rising prices. It is a part of our everyday lives which (both directly and indirectly) influences the decisions we and businesses make.
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This article has been provided by Todd McCullough – an independent blogger and finance researcher. He writes financial advice and money saving themed articles for financing and loan websites.
Image courtesy of DDPavumba / FreeDigitalPhotos.net
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