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JOHNATHAN CHARLES-CH3859270 ECO 213

EVALUATE THE EFFECTS OF INFLATION




The effects of inflation cannot be fully assessed in isolation as various factors such as the
rate of inflation, whether it is constant or accelerating and whether it is anticipated or unanticipated
determines whether it is beneficial or detrimental to the economy and individual and firm. High and
vociferous inflation is seen by economists as having a range of economic and social costs. It is for this
reason that there is continued importance on inflationary control by both the central bank and
governments. The impact of inflation on businesses and the consumer depends on whether inflation is
anticipated or unanticipated. Anticipated inflation denotes when people are able to make accurate
predictions as to the forthcoming rates of inflation so as to take steps to defend themselves from its
effects. A very practical example of this is trade unions exercising their collective bargaining power to
negotiate with employers for increases in their money wages so as to protect the real wages of the
union members. Households may also be able to switch savings to deposit accounts offering a higher
nominal rate of interest or in other financial assets such as housing or equities where capital gains over
time can outstrip the general level of inflation. Companies can adjust prices and lenders can adjust
interest rates businesses may also seek to hedge against potential future price fluctuations by
transacting in forward markets. World airlines are a typical example of businesses who transact in
forward markets. Unanticipated inflation conversely denotes that due to inflation becoming more
volatile year after year it then becomes difficult to predict the rate of inflation in the near future. This
situation would occur when errors are made in the forecasting of inflation resulting in the loss of profits
and real incomes. This can also result in the loss of investment and overall consumption as firms and
individuals are unaware of future inflation.
JOHNATHAN CHARLES-CH3859270 ECO 213
In relation to accelerating and stable inflation an accelerating inflation rate is more likely to
have a more staggering effect than one which is stable. If for example if inflation three years ago was
five percent, two years ago was eight and last year was fifteen. Then people are likely to expect a further
rise in inflation. The way they react is likely to bring about what they fear. Firms may raise prices to
cover expected increases in the costs of production and consumers may seek to purchase goods now
before their prices increase. Furthermore accelerating inflation will cause increasing uncertainty and will
discourage investment and time which should be devoted to predicting future inflation will be increased
as well as the costs involved. Contrastingly stable inflation will be easier to predict and people and firms
will be better able to protect themselves from its harmful effects. Against this backdrop we can now
examine the effects of high rates of inflation on an economy.
Firstly inflation leads to a rise in the general price level so money loses its value. When
inflation is high consumers lose confidence in the currency as the value of savings is severely
hemorrhaged. As stated previously savers will lose if the nominal value of interest is lower than the rate
of inflation-leading to the eventual decline of real interest rates. For example if a saver receives a
nominal rate of interest of 7 % on his account but the national rate of inflation is 10% then the real
interest rate is 3%. Additionally this may lead to more problems as higher wages will be demanded as
people will try to maintain their real living standards. Also as stated earlier businesses may try to retain
their profit, margins and protect themselves from potential spirals in prices by raising their prices. This in
turn will put additional pressures on wages given what we already know about the circular flow of
income. What has just been described is known as a wage price spiral. Another notable effect is that of
that arbitrary redistribution of real income. This means high inflation tends to hurt those employees
with less bargaining power in the labor market. These are those whose incomes are fixed and rise below
the national rate of inflation. For example peoples whose incomes are derived from fixed securities will
experience a fall in their real incomes. However if incomes are directly linked to prices-index linked- e.g.
JOHNATHAN CHARLES-CH3859270 ECO 213
state pensions real incomes will most likely stay the same relative to the rate of inflation.in a situation
such as this wages will most likely be rising higher than the rate of inflation as unions will advocate
vigorously on the behalf of their members to protect their interests and maintain their standards of
living (these are the parties with more bargaining power in the economy). Because of this the gap
between pensioners and wage earners is likely to widen during periods of high inflation. Inflation can
also favor the borrower at the expense of savers as inflation erodes the real value of existing debts and
the rate of interest on loans may not cover the rate of inflation. When the real rate of interest is
negative savers loose out at the expense of borrowers. Similarly inflation tends to encourage borrowing
and discourage lending as the real rates of interest have fallen.
In relation to incomes derived from profits this depends to a large degree on the type of inflation
being experienced. During demand pull inflation real profits tend to rise as there is a general increase in
AD. The prices of goods and services tend to rise higher than the prices of many factor=r inputs which
are usually fixed on long term contracts. The consequent action is that the margin between the two
price levels over time widening. Because the risks of trading in these conditions are greatly reduced
complacency and inefficiency are likely to emanate as the incentive for product and performance quality
are no longer preeminent. Contrastingly with cost push inflation profits may be squeezed as productive
output is reduced. bbecause of this reduction in excess demand firms may find it difficult to pass on the
full cost of their rising production constraints. In these types of conditions firms will place a greater
premium on efficiency as costs are increasing. Firms who cannot do this may end up cutting their labor
forces to cope or may not survive at all. This obviously would contribute to the overall unemployment
level and affect the growth potential of the economy. More generally inflation can disrupt business
planning. Budgeting becomes difficult because of rising inflation of both prices and costs. This reduced
planning coincides with reduced capital investment which in turn has a domino effect on the countries
long run growth potential. Inflation is also a possible cause of final unemployment in the medium term
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if one country experiences a much higher rate of inflation than another leading to a loss of international
competitiveness and a subsequent worsening of their trade performance.
Many of the costs listed above are those associated with high and accelerating rates of
inflation. Whilst there are clear disadvantages of this, there can be advantages of low stale rates of
inflation of say 2 percent. If the increases in the general price are caused by an increase in aggregate
demand then the firms can be optimistic about this as this denotes a higher price than initial cost and an
increase in profit for the firm. Inflation may also stimulate consumption, this is because real interest
rates may be low or negative if nominal interest rates do rise in line with inflation. Consequently debt
margins may be significantly reduced and people may be encouraged to spend more. An example of this
would be those who have borrowed money to buy a house may experience a fall in their mortgage
interest payments in real terms. At the same time the price of that same house is likely to rise by more
than inflation. This will increase consumer welfare and entice the consumer to spend more. Finally the
existence of inflation may be just what certain firms who need to reduce costs need to survive. With
zero inflation firms would have to cut their labor forces as this is the most constraining cost. However
with the prevalence of inflation firms have the choice of not raising nominal wage rates to line with
inflation hence reducing the real costs of labor or they can keep the nominal rates constant.