2.1.2 Consequences Of Inflation Flashcards
What are the four negative impacts on inflation on households
- falling real incomes
- rising inequality
- higher interest rates
- fiscal drag
Explain falling real incomes
If wages are not rising in line with inflation - erosion of living standards (fewer goods and services and potentially lower quality) and lower GDP
Explain rising inequality
Inflation has a regressive effect on lower income families in developed and developing countries - most of their health is held in cash so when the purchasing power falls they can buy fewer goods and services
Explain higher interest rates (households)
When inflation is high, the central bank will often raise interest rates in an attempt to curb inflation - this could increase the cost of borrowing for households
Explain fiscal drag (households)
Wages rise in line with inflation and an individual is dragged into a higher tax bracket therefore increasing government tax revenue without altering tax brackets
what are the three negative impacts of high inflation on firms
- business uncertainty
- interest rates rise
- lower revenue
explain business uncertainty
high and volatile inflation is not good for confidence because businesses cannot be sure of what costs will be - this might hold back investment
explain higher interest rates (firms)
when inflation is high, the central bank will often raise interest rates in an attempt to curb inflation - this could increase the cost of borrowing for firms
explain lower revenue
lower household real incomes can reduce spending, leading to lower revenue and profits for some firms
what are the four negative impacts of high inflation of the government
- welfare spending
- worsens government budget
- higher interest rates
- worsening of international competitiveness
explain welfare spending
pressure to raise the value of state welfare benefits including the state pension or out of work benefits to help control poverty/inequality
explain worsens government budget
high inflation can cause real GDP growth to slowdown - this can lead to lower tax revenues and the government then having to borrow more money (automatic stabilisers)
explain higher interest rates (government)
if the central bank raise interest rates to combat inflation, government borrowing is more expensive (increases national debt)
explain worsening of international competitiveness
causing a fall in exports as less price competitive which can then threaten jobs and GDP growth as well as worsening the trade balance on the current account of the BoP
what are three benefits of high inflation
- economic growth
- lower unemployment (cyclical)
- borrowers benefit
explain economic growth
if demand pull inflation occurs, then we can assume that disposable income has increased and therefore real GDP will increase
explain lower unemployment (cyclical)
if demand pull inflation occurs, then we can assume that disposable income has increased and therefore AD will rise so unemployment may fall as firms need workers to produce output to meet higher demand
explain borrowers benefit
the value of money that was borrowed is now worth less, meaning in real terms the borrower pays back less
what are the four benefits of inflation to the government
- fiscal drag
- benefits as a borrower
- higher tax revenue from firms
- macro objectives achieved
explain fiscal drag (government)
this happens when people’s wages/incomes are rising in nominal terms which causes them to pay more in direct and indirect taxation - greater tax revenue for government
explain benefitting as a borrower (government)
reduces the value of the government’s existing/outstanding debt
explain higher tax revenue from firms
moderate positive inflation (demand pull) helps businesses to make higher profits - this generates more tax revenues for the government via corporation tax and increased VAT payments
explain macro objectives achieved
higher growth and lower unemployment (if demand pull)
what do the consequences of inflation depend on
- rate at which inflation is rising
- whether inflation is stable or unstable
- whether the current rate is one which has been expected
- how UK inflation compares to other countries
- the type of inflation
- the balance between the pros and cons for different economic groups (e.g firms selling inferior goods benefit more)
what is the wage price spiral
- rising inflation
- real incomes fall if wage increases fail to keep up with the pace of inflation
- workers try to negotiate better wages (may be backed up by trade unions)
- unit labour costs for firms increase if wages rise faster than productivity
- firms pass on higher costs to customers to protect their profits
what is the short-run Phillips curve
illustrates a stable and inverse relationship between unemployment and inflation
explain the shape of the short-run Phillips curve
when unemployment is high then workers have very little bargaining power over their wages because they could be easily replaced by someone else in the pool of labour and employers have more bargaining power so wages will not rise.
what are some economic impacts of deflation
- rise in cyclical unemployment
- real interest rates rise
- real level of debt rises (so decreases confidence)
- declining business profits (due to lower spending and confidence)
- pressure for lower wages (but could decrease costs)
- decreased spending as consumers wait for prices to fall further
what are some possible benefits of deflation
- fall in general price level might increase real incomes of poorer families
- rise in demand for “value” products
- asset prices falling can improve housing affordability (important for first time buyers)
- savers benefit in real terms
- export prices more competitive
