(b) Discuss whether the domestic effects of inflation are more serious than the

external effects for an economy. [12/12]

Kn: Inflation
An: Domestic
: External
EV:
—
Noting that inflation is a sustained rise in general price levels over a certain
period of time, the impacts of inflation on the domestic economy can differ from
the impacts external to an economy.

An example of an internal effect of inflation is the lower standard of living that

the domestic consumers will experience. This is due to inflation causing the
diminishing purchasing power of the domestic currency, thus lowering the real
disposable income of the consumers. This will allow the consumers to be less
willing and able to purchase goods and services. However, this may not be
detrimental to the economy if there is a low rate of inflation, as consumers will
still be able to spend on goods and services at a similar but slightly lower rate.
On the other hand, if there is a high rate of inflation, and this persists over a
longer period of time, the economy may encounter hyperinflation, resulting in the
consumers not being willing and able to purchase goods and services as much as they
were, and would lead to a recession.

The economy may also experience external effects of inflation, where the terms of
trade will ultimately become more favourable as export prices increase. However,
they may also experience a lowered export quantity, as foreign countries choose to
purchase goods elsewhere due to these high export prices, resulting in a current
account deficit. This would then lead to lowered international competitiveness of
the economy. Furthermore, the economy may also encounter lowered rates of FDI, as
the increased prices would drive away potential foreign investors, leading to
lowered investment in the economy, preventing economic growth.

Overall, inflation may hold many negative effects, but the domestic effects of
inflation would be more serious in the short run as consumers are less willing and
able to spend, due to the value of the currency diminishing in real time. However,
in the long run, inflation would be more serious external to the economy in the
long run as there would be destimulation of the international trade of the economy.
It is notable that although one situation may be more serious that another during
either the short run or the long run, it must be noted that both must be addressed
in order to maintain a low and sustainable rate of inflation.