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Why is inflation bad?

In the first fact sheet in this series on the South AfricanReserve Bank (the Bank) titled “Introduction to theSouth African Reserve Bank”, was pointed out thatthe Bank’s mission is to protect the value of the rand,that is to combat inflation. This task has beenassigned to the Bank in terms of the Constitution andthe South African Reserve Bank Act 1989 (Act No. 89of 1989). What does this imply and what is inflation?Why is inflation bad?

What is inflation?

Inflation is a process of continual increase in the pricesof most goods and services in a country. This does notnecessarily mean that all prices increase. There maybe some exceptions, such as computer prices thathave actually declined in recent years. Inflation cantherefore be described as a persistent generalincrease in prices.

How inflation is measured

Inflation is measured by defining a basket of goodsand services used by a "typical" consumer and thenkeeping track of the cost of that basket. In the 12 months up to January 2007, the cost of thatbasket rose by 6 per cent. This increase of 6 per centin the so-called consumer price index is referred to asthe inflation rate. From 1974 to 1992 the South Africaninflation rate has ranged between 10 and 20 per cent.It has been brought down to less than 10 per cent perannum since 1993.

Why is inflation bad?

Inflation is regarded as a bad process because it leadsto distortions and problems in an economy. A short listof the key disadvantages of inflation includes thefollowing:

Losses to savers: If you save your money by hoardingcash, inflation erodes the purchasing power of theamount saved. For instance, R100 put underneath amattress ten years ago can now purchase only onethird of the goods and services that it could have donein 1987. (See Graph 1 on p. 3.) Even if you save in theform of savings deposits which pay interest, theinterest may not be enough to compensate you in fullfor inflation. This also applies to pension planning,where people may, for example, save for a pensionduring their entire working life, just to find at the end oftheir career that their savings have been eroded byinflation.

Losses to people with fixed incomes: People withfixed incomes (such as the interest on a fixed deposit,

or a fixed salary) find that the purchasing power oftheir income diminishes over time. The wealthy, bycontrast, can usually partly protect themselves againstinflation by investing in assets, such as shares orproperty, which increase in value during periods ofinflation. Inflation therefore leads to an increase in thedisparity between the wealth of the "haves" and thepoverty of the "have-nots", or the rich and the poor.

Losses to taxpayers: If your salary increases in linewith inflation, and no adjustments are made to incometax, you will shift into a higher tax bracket and end uppaying a larger share of your salary to the tax office.This means that government gains control over anincreasing proportion of society's resources withoutformally getting the approval of Parliament to raisetaxes.

Confusing price signals to producers and slowerexpansion of businesses: A higher price for a productwould usually indicate that people want more of thatproduct, that more profits can now be made from itand that more resources should therefore beemployed to produce it. In times of inflation, however,an increase in the price of a product can occur eithersimply as part of the regular inflation-relatedadjustments to prices, or because the demand for thatproduct has risen permanently. Entrepreneurs, notknowing which of the two kinds of price increaseshave occurred, may wait much longer beforeexpanding their businesses and employing moreresources in reaction to a permanent increase indemand.

Speculation crowding out production: An environmentof high inflation and financial instability leads to moreentrepreneurship and other resources being devotedto speculation in existing assets such as real estate,and less to the expansion of production andemployment.

Reduced attention to productivity: Higher productivityis an important sustainable way of improving theoverall standard of living in a country. In the absenceof inflation, wage negotiations are focused on propercompensation to employees in accordance withimprovements in their productivity. With high inflation,salary or wage increases consist overwhelmingly ofcompensation for inflation, and productivity issuesbecome less important and may be neglected.

Wastage of resources: During very high inflationepisodes (fortunately this has not happened in SouthAfrica) prices have to be increased daily. A shopassistant, for example, may have the full-time job ofwriting a new price on each item every day orupdating a list of the prices of the various articles. The

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assistant would, without inflation, have been able todo more productive work, such as selling items toclients. The lower the inflation, the less time is spenton the repricing of items.

Heightened tension and social disruption: A societyplagued by high inflation devotes more energy toredistributive issues, in which case each person orgroup perpetually tries to gain or regain a better price,wage or position. This destroys the fabric of society in awider sense than simply through its impact on theproduction of goods and services.

Claims are often made by ill-informed people thatinflation is not bad. They argue that higher inflation willstimulate economic growth.

These claims are false. It is quite easy and inexpensiveto print more money, thereby boosting inflation; even

the poorest countries could do that. If this were the wayto achieve economic prosperity, no poor countrieswould remain on earth. If money is printed to stimulatethe economy, it may work for a short period , but peoplewill soon realise what is going on and instead ofproducing more, they would simply start to increaseprices and wages much more rapidly. In the end, thecountry would face high inflation with all the destructiveand distortive effects outlined above, and wouldcertainly be left with a weaker economy.

The South African Reserve Bank, like central banks inmost countries, is therefore strongly opposed toinflation, and uses its monetary policy to combat it.Such policy action is conducive for continued economicgrowth, prosperity and a fair distribution of income andwealth. Low inflation and a stable financial environmentare indeed prerequisites for the achievement of theseobjectives on a sustainable basis.

Graph 1: Consumer prices Percentage change over one year

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This is the second in a series of fact sheets on the South African Reserve Bank, compiled by the Research Department: Information Division anddistributed by the Strategy and Communications Department..

Available: http://www.reservebank.co.za

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The content of this fact sheet is subject to change at any time. Last updated: March 2015