vicing nominal debt contracts.2) Unanticipated inflation – with this the costs can be much higher. They are as follows: Redistribution costs between borrowers and lenders. This redistribution occurs when the real rate of inflation exceeds the real rate of interest, so people who have borrowed money can actually end up paying back less than the value they borrowed. Distortionary effects1) Confusions between relative and average price levels2) Discouraging long term investment projects – if there is too much uncertainty over future rates of interest and inflation, cost benefit analysis cannot be applied to future projects and investments, returns cannot be calculated so less investment takes place.3) Savers and Lenders may demand a risk premium – if they recognise the problem of redistribution costs, they will want to increase their interest rates to allow for this.4) Savers and investors may form different expectations of inflation, possibly resulting in a misallocation of capital: if an entrepreneur with a safe project approaches an investor who thinks the future is risky, he may be offered a rate of interest that is too high for him to make sufficient profit, and so the project will be shelved. However, if an entrepreneur with a risky project approaches an investor who thinks the future safe, he will be offered a more affordable rate of interest than if inflation was stable – and hence a misallocation of capital results.Costs to UKThe costs to the UK of the inflationary spiral of the 70’s Oil crises were: inflation of 13.4% in 1979, rising to 18% in 1980. The Government tried to counter this with medium term (4 year) financial strategy targets, focused on tightening the supply of M3 (notes and cash in circulation, plus bank deposits) but because a high proportion of M3 is interest bearing, high interest rates induced people to hold more of it, hence a decline in M3 velocity. Monetary growt...
