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How does inflation affect the economy

how does inflation affect the economy

The consequences of inflation can be categorised into two areas: output effects and redistribution effects.

1. Output effects:

Continual price rises lead to uncertainty about the future (particularly when inflation rates are high, or where there is a wage-price spiral), and thus making decision-making more difficult for consumers and the business sector. Investment decisions become more risky in an inflationary environment because uncertainty about future costs and prices makes it difficult for decision-makers to be certain about the rate of return which can be earned on investment. If inflation leads to higher risk on capital expenditure, then it must lead to lower output and employment opportunities.

Capital-for-labour substitution can occur if wages rise faster then productivity. Rising costs have been responsible for other structural changes in the economy. In Australia, for example, the oil shocks of the 70s resulted in greater emphasis on energy-saving techniques of production and distribution. The shocks caused a move towards more fuel-efficient vehicles than larger cars.

Inflation also causes a lack of confidence in money as a store of value, and people often seek ways around price rises that they expect in the future. One way to hedge against inflation is to purchase assets which are likely to appreciate in value, such as antiques, property or precious metals. Speculative activity has negative effects on the potential output of the economy if it becomes an easier way to create wealth than productive activity.

Hyperinflation (rates of inflation above 30%) can lead to economic collapse if there is a diversion of effort towards hoarding or non-productive activity. Under extreme circumstances, people lose confidence in money as a measure and store of value. Normal trading relationships can not continue in such a situation.

International competitiveness is influenced by relative inflation levels. A country will be at a disadvantage if its domestic inflation is greater than its competitors. Inflation affects the current account deficit (CAD) because then demand for exports falls as prices rise, and because imports become more

competitive if import prices fall relative to those of domestic competitors.

The relationship between inflation and the exchange rate is a double-edged sword. Ongoing inflation tends to cause a currency to depreciate (because there is less demand for that country's goods). Usually, depreciation assists exporters because prices paid by overseas buyers fall. However depreciation means that prices of imports rise, which is inflationary. The net effect of depreciation in inflation depends upon the relative price elasticities of imports and exports.

2. Redistribution effects:

Some households are worse off than others in periods of inflation (for example, living standards of low income earners and pensioners will fall unless the payments are indexed to the price index). Some others may be able to arrange their financial affairs to benefit from expected price increases. For example, sectors with market power such as business owners who can pass on price increases to their customers. They seem to be more capable of maintaining their real incomes.

Lenders suffer during periods of inflation, unless the rate of interest they are charging is enough to cover the rate of inflation, and allow for a real return on money lent. Long-term lenders will be repaid in inflated dollars which have reduced purchasing power.

Borrowers tend to benefit from inflation, because they can build up their assets on borrowed money, knowing that the real value of their repayments will fall over time.

Taxpayers may be subject to bracket creep as inflation gradually causes their income levels to rise to levels where they are liable for higher marginal rates of taxation. Govt. revenue increases as a result of this bracket creep.

The redistributive effects partly depend upon how well price increases were forecast (or anticipated) by the community. If the extent of price movements is correctly anticipated, then redistributive effects are not as great.

Edit: I apologise for the length of my answer, I didn't expect it to be this long.

Anonymous · 8 years ago

Category: Bank

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