Consequences and Costs of Inflation:

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    Consequences and Costs of Inflation:

    • Personal Costs:
      • Reduce purchasing power
      • Real income falls
      • People like pensioners and students on fixed incomes will suffer from inflation.
      • Low paid and non-unionized workers often fail to get sufficient rises to stop real income falling.
      • Professional workers may ask for wage increases that protect or cause increases in real wage levels.
      • Savers and lenders may be hurt by inflation rate if interest is less.
      • People who borrowed may benefit.
      • Demand-pull inflation increased spending can boost company profits, while cost-push may reduce profits. Rising profits could yield more tax, however government may have to pay more for goods and services.
      • Economical Costs:
        • Possible unemployment – purchasing power drops, less demand
        • Some people save more, reducing economic activity and overall output
        • Causes goods and services to become uncompetitive  internationally
        • Benefits:
          • Economic growth
          • Reduce debt values – falling value of money reduces real debt values
          • Higher stock value
          • Values of fixed assets could rise – financial security
          • Possible increased employment
          • Stimulate technological advancement

    Economic Growth and Inflation

    Most governments hope that they can achieve steady economic growth without it causing acceleration in demand-pull and / or cost-push inflationary pressures. The dangers of a booming economy is that inflationary pressures build and that the economy must slow down or fall into recession for these inflation risks to be controlled.

     

    • During the early part of the last decade, the British economy enjoyed a period of steady growth and relatively low and stable inflation
    • In 2007-08 the trade-off between growth and inflation worsened
    • Inflation surged higher – mainly because of external factors such as high food and oil prices
    • The economy suffered a steep descent into recession following the global financial crisis
    • In early 2009 the economy experienced recession and higher inflation – some economists warned of a lengthy phase of “stagflation” conditions
    • Inflation fell back largely because of the recession. But in 2010 and into 2011, inflation has been rising again whilst GDP growth has been weak with the risk of a second downturn (a “double-dip”)

    Stagflation

    Stagflation is a period of economic stagnation accompanied by rising inflation. In other words, both of these key macro objectives are worsening. It can happen when an economy goes into a downturn or a recession but when other external forces are bringing out higher inflation. The obvious example of this is when recession is afflicting a country but the prices of imported products are surging causing prices to rise and real incomes and profits to fall.  The rise in the cost of imports can be shown by an inward shift in the short run aggregate supply curve leading to a contraction in real national output and an increase in prices.

     

    One of the dangers of stagflation is that the fall in real incomes causes consumer and investment spending to fall and thus the rate of economic growth suffers too (a deterioration in a third objective of policy). Wage demand may also pick up as people experience rising prices. The central bank needs to consider appropriate policy responses to this. Too severe a tightening of monetary policy for example will help to curb inflation but risk causing a deep recession.  The combination of deflation and a sustained drop in economic output is termed an economic depression

     

    An improvement in aggregate supply can help to resolve the growth – inflation trade off. We see in the diagram how aggregate supply has moved outwards and this allows aggregate demand (C+I+G+X-M) to operate at a higher level without threatening a persistent increase in the general price level (inflation).

    Overcoming a conflict between economic growth and inflation – increases in AD and AS

    Conflicts between objectives – the economics of deflation

     

    Deflation is a sustained fall in the prices of goods and services, and thus the opposite of inflation. Increased attention has focused on the impact of price deflation in several countries in recent years – notably in Japan (inflation -0.3% in 2010) and in some Euro Area countries such as Ireland Greece where prices have been falling, national output has dropped and unemployment has been rising.

     

    It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP. But deflation can be caused by rising productive potential, which leads to an excess of aggregate supply over demand.

    Deflation is a sustained fall in the prices of goods and services, and thus the opposite of inflation. Increased attention has focused on the impact of price deflation in several countries in recent years – notably in Japan (inflation -0.3% in 2010) and in some Euro Area countries such as Ireland Greece where prices have been falling, national output has dropped and unemployment has been rising.

     

    It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP. But deflation can be caused by rising productive potential, which leads to an excess of aggregate supply over demand.

    Greece has suffered from a severe rise in unemployment (right hand scale) and is now seeing her relative living standards fall. A deflationary depression is a risk for Greece

    Possible damaging consequences of persistent price deflation

    • Holding back on spending: Consumers may postpone demand if they expect prices to fall further in the future.
    • Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on consumer confidence and people’s willingness to spend. This is especially the case with mortgage debts and other big loans.
    • The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices. If inflation is negative, the real cost of borrowing increases and this can have a negative effect on investment spending by businesses
    • Lower profit margins: Lower prices hit revenues and profits for businesses – this can lead to higher unemployment as firms seek to reduce their costs by shedding labour.
    • Confidence and saving: Falling asset prices including a drop in property values hits wealth and confidence – leading to declines in AD and the threat of a deeper recession.

    Resolving the threat of price deflation

    • Using expansionary Monetary Policy
      • Interest rates: Deep cuts in interest rates can be made to stimulate the demand for money and thereby boost consumption
      • Quantitative Easing – printing money in the hope that, by injecting it into the economy, people and companies will be more likely to spend.
    • Using expansionary Fiscal policy
      • Keynesian economists believe that fiscal policy is a more effective instrument of policy when an economy is stuck in a deflationary recession and a liquidity trap
      • The key Keynesian insight is that a market system does not have powerful self-adjustments back to full-employment after there has been a negative economic shock. Keynes talked of persistent under-employment equilibrium – an economy operating in semi-permanent recession leading a persistent gap between actual demand and the potential level of GDP.

     

    Keynes argued that this justified an exogenous injection of aggregate demand as a stimulus to get an economy on the path back to full(er) employment and to prevent deflation.

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