Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Appraising Inflation: Good or Bad?

If you ask non-economists how they feel about inflation, they probably tell you that they hate (or at the very least, dislike) it. But despite agreeing that high levels of inflation are very costly and never a good idea, economists also see a couple of potential benefits in inflation.

In fact, although some economists suggest that the optimal inflation rate is zero, many believe that an economy should have a small positive amount, something that most central banks try to achieve.

In this section you discover the social costs and benefits of inflation.


Counting the costs of inflation

The reason laypeople typically give for not liking inflation is that it makes them poorer. This is a valid concern, especially because the wage specified in an employment contract is almost always the nominal wage – for example, ‘this year you’ll be paid £15/hour’ – which will, of course, buy a lot less at the end of the year than at the beginning of the year, if inflation is high.

Economists, however, look at inflation slightly differently, because over time nominal wages (the wage in money terms) tend to at least keep up with inflation. In fact, most of the time, nominal wages tend to rise faster than inflation – which is the same as saying that the real wage (the wage in terms of goods) tends to rise over time.

Sometimes real wages do fall, though. For example, you may have noticed that in the years after the 2008 financial crisis, real wages fell for many people in the UK and other places. Although this represents a struggle for many families, economists discern a possible silver lining – more on this in the later section ‘Appreciating two benefits of inflation’.

Shoe-leather costs

Cash is great. With cash you can easily purchase goods, which is why economists say that cash is highly liquid. What’s not so good about cash is that holding it offers no return: a £10 note today is still a £10 note next year.

Without inflation the real value of cash would remain constant over time. But with inflation, the real value of cash falls over time: a £10 note buys you less next year than it does today. Economists care about this because inflation, especially high levels of it, means that people and firms have to spend time and effort continually adjusting their money holdings so inflation doesn’t erode too much of their wealth.

Suppose that you have £50,000 of savings. You can decide to keep it all in cash (or, similarly, in a current account that pays little or no interest). The good thing would be that you always have cash handy to make a purchase.

But this may not be a great idea – if inflation is high every year, your savings would be worth less and less.

Another possibility is that you keep all your savings in an illiquid savings account that pays you a good rate of return. This way you’re maximising the return from your savings. But every time you want to buy something, you’d need to withdraw funds from your savings account, which is ridiculous. Can you imagine having to visit your bank before buying anything?

The best thing to do would probably be something in the middle. Keep most of your savings in a high-returning account while maintaining a reasonable amount as cash or in your current account. Nevertheless, even in this case you need to manage your finances carefully – making sure to transfer money as and when it’s needed.

The time and hassle of thinking about and making these transfers to your money holdings comes under the heading shoe-leather costs. This funny name refers to the fact that travelling backwards and forwards to your bank wears down the leather soles of your shoes! Even though today people don’t tend to visit their bank physically to withdraw funds, the name has stuck.