Is a sustained rise in the average prices of goods within an economy. It is also useful to understand it as a fall in the purchasing power of money, since it is usual for wages to move ahead at least as fast as the price level. Inflation can be divided into two types: cost-push inflation and demand-pull inflation, to distinguish between prices being pushed up by rising costs or being pulled up because demand has outstripped supply. In practice, the two very quickly become indistinguishable. As prices rise for whatever reason, people negotiate wage increases to maintain their standard of living, anticipating future levels of inflation and thereby helping those levels to come about. (See inflationary expectations and inflationary spiral.) Monetarists argue that inflation is brought about by an unnecessary increase in the money supply in excess of the production of goods and services available in the economy. If inflation reaches very high levels, it is known as hyperinflation.
Inflation can have positive and negative effects on firms:
• for firms with heavy borrowings, inflation reduces the real value of the sum outstanding, making it easier to repay the loan at the end of its life. For example, if a firm borrowed £4m ten years ago, and inflation since then had doubled the price level, the loan would be much easier to repay from the firm’s doubled level of income
• small firms can benefit from consumers’ increased price sensitivity, since theirs are usually the more price elastic products
• the producers of major brands suffer as the regularity of price increases in the shops makes consumers focus far more on the price of what they buy. Brand-loyal customers start to look at prices instead of just picking their favourite from the shelf. This increased price sensitivity leads to brand switching towards the more competitively priced items, thereby reducing the value added by brand names. The owners of the brands must either cut their price premiums, or greatly increase their advertising expenditure in order to restore their value added
• Just as consumers focus more upon prices, so workers become far more concerned about their wage levels, for unless they can obtain a pay rise at least as high as the level of inflation, their real incomes will fall. Therefore industrial relations can worsen sharply in inflationary times, with workers pushing their union representatives to be far more forceful about pay increases.