INFLATION: Is a Decrease in Inflation always Beneficial?

What are the Benefits of a fall in the Rate of Inflation? 

Inflation can be defined as a sustained rise in the price level over a period of time. Also the inflation rate can be defined as a sustained rise in the price level measured in percentage terms.

A fall in the rate of inflation can bring several benefits.

A decrease in the rate of inflation will lead to greater certainty and a greater ability to plan ahead, which firms and companies like. With this greater certainty more firms are likely to invest more which will in turn increase aggregate demand (because investment is a component of AD). This therefore means increases in real GDP and economic growth.

However, there can be fluctuations in inflation which can lead to the polar opposite: greater uncertainty within firms and companies. This would then cause reduced levels of investment and so a fall in aggregate demand/economic growth. This can in reality have detrimental effects on an economy.

A decrease in the rate of inflation, if it falls too low, causes prices to fall but also sets off a downward deflationary spiral whereby households and firms will put off buying things and investing until a later date, where it will be relatively cheaper as a result of the deflation or negative inflation. This therefore reduces or stops investment meaning that aggregate demand falls and so unemployment levels would increase combined with a lack of economic growth.

The benefits of a fall in the rate of inflation can only be determined by what caused it. For instance, a cost-push inflation decrease is worse than a reduction in demand-pull inflation. A fall in cost-push inflation is better because, if it decreases then costs and prices fall meaning that our domestic products will be more internationally competitive. This would cause the quantity of exports to rise which, in the UK where we possess a current account deficit, would counteract it and cause a movement towards a surplus on the balance of payments.

However, a fall in demand-pull inflation could cause a fall in aggregate demand which would cause greater unemployment levels if the productive capacity of the country increases at a faster rate than that of aggregate demand.

Furthermore, adding on to how it can be determined by what caused it, one must take into account the relative rate of inflation with respect to other countries. Even if a fall in inflation makes a country’s goods more internationally competitive, if another country’s goods are cheaper than ours after the fall in inflation then we’re still lesser off as their goods remain cheaper and so the demand will be higher for their goods. Even if it is lower than the inflation rates of other countries, there is still the possibility that the prices of our goods may still be higher. Resulting in less international competitiveness which could increase a deficit on the balance of payments.

However, it also depends on what the relative exchange rate is. This is because a higher rate will put other countries off and so should be taken into account in assessing the fall in the rate of inflation.

If you fancy learning more about economics and the financial world around you check out my other articles on my blog: http://insighteconomics.blogspot.co.uk/

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