Will Lower Inflation Boost British Economy?
Because of the pound's relentless appreciation relative to the euro, British inflation has finally started to fall, though at 2.4% it is still not lower than the euro area average.
This is now spun by some reporters as bullish for the U.K. economy because it means that consumer purchasing power increases. But while it is good that it is acknowledged that there are positive aspects of disinflation/deflation these people make the same mistake as those who argue that higher inflation is positive for the economy.
In terms of the direct effect, a price change is a zero sum game. A seller benefits from a higher price, or in other words benefits from higher price inflation, while the buyer benefits from a lower price or a lower rate of price increase, or in other words the buyer benefits from disinflation and deflation- But since everyone are both buyers (in their role as consumers) and sellers as workers selling their selling their services in exchange for a wage or salary and/or as investors owning the company that sells products) the aggregate effect of both higher and lower inflation will be neutral.
This is not to say that inflation is neutral if you count in indirect effects, because clearly it isn't as it can for example distort relative price something that can both have redistributional effects between different individuals and for example create asset price bubbles or dramatic exchange rate movements. The latter means that inflation will have disruptive effects that weakens growth. But in terms of its direct effect on aggregate purchasing power it is neutral (assuming of course that terms of trade isn't changed) as an increase in inflation means higher nominal income and a decrease in inflation means lower nominal income.
Interestingly the same newspaper that published the above mentioned story about the beneficial effects that the strong pound induced decline in inflation have, also published a story about how the strong pound has detrimental effects for exporters. Which is of course an illustration that the purchasing power increasing effect of lower inflation will for the U.K. economy as a whole be cancelled out by lower nominal incomes for exporters and suppliers of exporters, just as the previous purchasing power increasing effect that the previously weak pound had in terms of raising nominal income was cancelled out by higher inflation caused by the same weakness in the pound.
This is now spun by some reporters as bullish for the U.K. economy because it means that consumer purchasing power increases. But while it is good that it is acknowledged that there are positive aspects of disinflation/deflation these people make the same mistake as those who argue that higher inflation is positive for the economy.
In terms of the direct effect, a price change is a zero sum game. A seller benefits from a higher price, or in other words benefits from higher price inflation, while the buyer benefits from a lower price or a lower rate of price increase, or in other words the buyer benefits from disinflation and deflation- But since everyone are both buyers (in their role as consumers) and sellers as workers selling their selling their services in exchange for a wage or salary and/or as investors owning the company that sells products) the aggregate effect of both higher and lower inflation will be neutral.
This is not to say that inflation is neutral if you count in indirect effects, because clearly it isn't as it can for example distort relative price something that can both have redistributional effects between different individuals and for example create asset price bubbles or dramatic exchange rate movements. The latter means that inflation will have disruptive effects that weakens growth. But in terms of its direct effect on aggregate purchasing power it is neutral (assuming of course that terms of trade isn't changed) as an increase in inflation means higher nominal income and a decrease in inflation means lower nominal income.
Interestingly the same newspaper that published the above mentioned story about the beneficial effects that the strong pound induced decline in inflation have, also published a story about how the strong pound has detrimental effects for exporters. Which is of course an illustration that the purchasing power increasing effect of lower inflation will for the U.K. economy as a whole be cancelled out by lower nominal incomes for exporters and suppliers of exporters, just as the previous purchasing power increasing effect that the previously weak pound had in terms of raising nominal income was cancelled out by higher inflation caused by the same weakness in the pound.
posted by stefankarlsson at 3:17 PM
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