Unit-10 150 Inflation M/J 14/P22/Q4/ab Distinguish between the domestic and external consequences of inflation and discuss which is most damaging to an economy. [12] SUGGESTED ANSWER: For analysis of the consequences o| flation (up to 8 marks) For analysis of domestic consequences of inflation (up to 6 marks) Interest is a reward for savings, and during inflation, real interest rates, i.e. nominal interest rate minus inflation rate, fall, discouraging savings (up to 2 marks) Fixed wage eamers lose, as, unlike businessmen, they cannot shift the burden of higher cost of living to others by raising the prices of the goods they sell (up to 2 marks) Higher inflation causes uncertainties and makes planning, budgeting and costing difficult. It discourages investments and long term contracts (up to 2 marks), During inflation, the value of money falls, reducing its ability to act as a medium of exchange and store of value (up to 2 marks). For analysis of external consequences of inflation (up to 6 marks) Higher inflation makes locally made goods less competitive both at home and abroad (1 mark), resulting in decreased exports and increased imports (1 mark), worsening the current account | balance (1 mark) Higher inflation causes uncertainties and discourages foreign investments (1 mark). Higher inflation decreases exports, and hence, the demand for local currency in the international market falls, leading to depreciation of exchange rate. Higher inflation increases imports, and hence, the supply of local currency in the international market increases, leading to depreciation of exchange rate (up to 3 marks). For evaluation of the effects that are more damaging (up to 4 marks) The external consequ when aces are more damagir * a country relies heavily on exports (1 mark) ie. the trade balance occupies a greater part of the national income (1 mark) * inflation is comparatively nigher than other trading partners (1 mark) * inflation is increasing over the years (1 mark) * the price elasticity of demand for net exports exceeds 4 (1 mark) * the exchange rate is fixed (1 mark) Accept an approach where the candidate concludes that domestic consequences of inflation could be more damaging, provided a sound argument is given.