Economics: Notes for Teachers Effects of Inflation Effects of Inflation Academic PowerPoint

Effects of Inflation Inflation is a macroeconomic problem which can have significant detrimental effects for an economy. The rise in the general level of prices (inflation) translates into a fall in the value of money – an undesirable situation.

Effects of Inflation The effects of inflation are normally catergorised into two areas: (i) Output effects on income, output and employment (ii) Redistribution effects of income and wealth in the economy We discuss these in detail on the following slides.

Output effects Uncertainty – Inflation increases uncertainty about future outcomes. Businesses invest on the basis of expectations. Hence, inflation will tend to reduce productive investments and increase speculative investments (e.g. purchase of property and antiques). It also reduces consumer confidence, increase savings, decrease spending on durables and may reduce output and employment.

Output effects International effects – If the rate of inflation is higher than our trading partners and competitors, then imports become relatively cheaper and exports become relatively more expensive (international competitiveness reduced). This is likely to reduce national output and employment, as well as increase the Current Account deficit.

Output effects Tighter monetary policy – Increases in inflation will force interest rates upwards to maintain real interest rates. This may reduce investment and consumption, and have a negative impact on output and employment. Tighter fiscal policy – Government expenditure may be reduced in a period of inflation in an attempt to lower aggregate demand. This may also reduce output and employment.

Output effects Capital-for-labour substitution – increasing wage rates cause uncertainty whereas the cost of purchasing capital is certain. This effect occurs mainly in unskilled labour markets.

Redistribution effects Inflation affects the community on an uneven basis and causes a redistribution and reallocation of resources. Much of the effect depends on whether the inflation is anticipated.

Redistribution effects Borrowers gain at the expense of lenders – the real value of a loan falls in times of inflation. However, interest rates are normally adjusted to account for any inflation. People on fixed incomes fall behind as the purchasing power of their incomes is reduced in times of inflation, e.g. recipients of welfare benefits.

Redistribution effects Strongly unionised essential service workers benefit by using industrial ‘muscle’ to gain wage increases above the inflation rate. Monopolies in key industries can raise their prices ahead of inflation to maintain or increase profits.

Redistribution effects Government may benefit because as incomes rise, people pay a higher rate of tax. This process is known as ‘bracket creep’. The record boom period of the 1990’s saw many people forced into higher tax brackets in many developed countries.

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