The Effects of Inflation and Deflation

Understanding the consequences of inflation and deflation is essential for evaluating macroeconomic performance and assessing the effectiveness of government policy. The effects depend critically on whether inflation is anticipated or unanticipated, its rate, and its persistence.

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Why Does Inflation Matter?

The Bank of England targets CPI inflation of 2%. But why not 0%? A moderate, stable, and predictable rate of inflation is generally considered beneficial because it:

• Allows relative prices and wages to adjust more easily (since nominal wages are sticky downwards)
• Provides a buffer against deflation
• Enables central banks to set negative real interest rates when needed to stimulate the economy

The costs arise when inflation is high, volatile, or unexpected.

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Costs of Inflation

1. Menu Costs

Key Definition: Menu costs are the costs to firms of changing prices — updating price lists, reprogramming tills, reprinting catalogues, and adjusting vending machines.

In periods of high inflation, firms must change prices frequently, which consumes time and resources. The name derives from the cost of reprinting restaurant menus. In the digital age, menu costs are lower for online retailers but remain significant for physical businesses.