Effects of Inflation explain the effects of inflation on households and firms explain the effects of inflation on growth and trade

Inflation and Households Purchasing power = The amount of goods and services which can be purchased by a person’s income Purchasing power: –Inflation reduces purchasing power (get less for same price). i.e. family on an income = $100/week, they buy one product worth $5. This means they can purchase 20 of this good. But if the price were to increase to $10 for the product they could now only purchase 10. Prices increase which results in a higher cost of living

Impacts of Inflation on Households Savers LOSE Inflation creates a disincentive to save, people are more likely to spend money now before prices increases Inflation erodes the real value of savings i.e. your savings buy less goods and services than they did before. [Note: interest rates compensate for this but your real return is still reduced e.g. if interest rate on savings is 6% then your savings are increasing in value by 6% but if inflation is 4% then your savings are decreasing in value by 4%. Overall your real return is 2%]

Real interest rate = the nominal interest rate – inflation rate

Impacts of Inflation on Households Borrowers: WIN Inflation creates an incentive to borrow as borrowers pay back less in real terms –i.e. the dollars which are repaid buy less goods and services than before. As assets increase in price during times of inflation people can borrow more against the asset – i.e. if banks let you borrow 80% of the value of your home then if the value of your home increases then you can borrow more money.

Impacts of Inflation on Households Borrowers: WIN [continued] Leverage - the amount borrowed as a percentage of the value of an asset falls if the asset increases in price/value due to inflation e.g. buy a house for $ and borrow $ to finance it [ loan = 80% of the house value]. Over the next 5 years The value of the house rises to $ due to inflation. The original amount of the loan is now only 66.67% of the house value

I would like to borrow $100 please Mr Krabs, to buy Gary a new bed Ok, I will lend you $100 but in one year you must pay back 6% interest meow

MEANWHILE Prices in bikini bottom are rising at 10%! Who will be better off in a years time, Mr Krabs or Spongbob?

Here’s your $106 Mr Krabs But…. Prices have rose by !0%, if I wanted to buy a new cash register a year ago I would only have to pay $100, now I have to pay $110

Real Income = Income adjusted for inflation. Income in terms of what it can buy. Nominal Income = A persons income in monetary terms.

Impacts of Inflation on Households Fixed Income Earners: LOSE Their income falls in real terms – i.e their income stays the same as prices rise so their income buys less. This especially affects those people on benefits such as the unemployment benefit or superannuation.

Incomes that rise faster than inflation: WIN Those people who get paid commission based on the value of what they sell may find their income increases as prices/values increase. Also people whose skills are in high demand or who are members of strong unions may be able to demand larger pay increases. Impacts of Inflation on Households

Fiscal Drag: LOSE As people’s income tend to increase during inflation they move into a higher marginal income tax bracket – meaning they pay a higher tax rate.

Impacts of Inflation on Households Planning/Budgeting: LOSE More difficult to budget for day to day living expenses or plan ahead to buy assets such as houses because it is more difficult to know what prices will be in the future.

Impacts of Inflation on Households Holders of Real Wealth: WIN The value of assets such as houses tends to keep pace or rise more than the inflation rate. Asset owners benefit from a rise in wealth

Inflation and Households Inflationary expectations: –When we expect inflation to occur, we buy goods and services before we normally would to beat the price rise, but instead help cause inflation.

Workbook page 45-46

Impact of Inflation on Firms

Increase cost of resources - LOSE Inflation forces up firm’s production costs. –Increased costs of resources Resources cost more to buy therefore profits will go down. –E.g. materials, fuel. –Firms will either pass increased costs to consumers by increasing price (which can cause a decrease in demand for their product) OR they will keep the price the same and decrease their profits.

Firms and Inflation Increased demand for wage rises Firms will feel pressure from unions to pay higher wages if inflation continues to exist. This reduces their profits and may cause redundancies.

Investment LOSE Investment = Purchases of capital equipment Capital equipment = Man made goods used to produce other goods and services. E.g. Hammer, computer, printer, tractor Inflation causes prices of factories, machinery and vehicles etc. to rise so it is more expensive for firms to expand. Inflation causes business confidence to fall and discourages investment as higher returns are needed to compensate for inflation and so investment is seen as a higher risk.

Planning: LOSE Makes planning more difficult as future costs and prices are harder to predict if they are increasing..

Investment Loans -Borrowing: WIN Inflation encourages debt as the amount you have to pay back falls in real terms. This makes investment loans cheaper as real amount borrowed falls. Can borrow more against value of firm’s assets

Speculation Speculation: Buying goods/resources now as you believe the price will rise in the future. Businesses are more likely to speculate on non productive assets that are likely to increase in price quickly during times of inflation e.g. buying sections of land

Exporters: LOSE Inflation pushes NZ costs of production up –E.g. a good that costs $100 to make will soon cost $110 to make The higher costs of production will then usually be passed onto consumers (our international trading partners).by an increase in prices which means NZ exports are less price competitive overseas leading to less demand from overseas and a fall in exports. Producers may decide to leave overseas price unchanged and take a cut in profits in order to remain competitive.

Importers: WIN Imports become more price competitive. If NZ’s inflation rate is higher than other countries we trade with then the price of imported goods rises less than the price of NZ goods so they become more price competitive.

Workbooks page 47-48

Impact of Inflation on Government Government Spending e.g. Rising costs/prices means Govt. will have to spend more on health, education, police etc. Beneficiaries may demand benefit increases to offset the the fall in real income/purchasing power. Government Income e.g. Increased spending due to higher prices/inflationary expectations will increase GST revenue. Rising incomes will mean more people in higher income tax brackets so more income tax revenue.

Impact of Inflation on Government Operating Balance Increased Government spending has a negative effect on the operating balance Increased tax take through GST and income tax will have a positive effect on the Government operating balance Overall effect of inflation on the operating balance depends if the positive effect of increased tax is greater or less than the negative effect of increased spending.