2.1.2 - Costs and benefits of inflation Flashcards
Name the Costs of Inflation
. Purchasing Power falls
. Menu Costs
. Reduced International Competitiveness
. Anticipated Inflation can create inflation spirals
. Fiscal Drag
Explain ‘Purchasing Power Falls’
Cost of Inflation
. Those who are on fixed incomes will suffer a decrease in their real income
. As a result consequence spending power reduces, reducing consumption in the economy and therefore aggregated demand decreases
Explain ‘Menu Costs’
Cost of Inflation
. Menus, catalogues and labels all need re - printing as a result of high inflation
. The cost of doing this are expensive due to labour costs and costs of printing
. This further accelerates the cost of inflation, as cost of production increases resulting in suppliers increasing price
. SRAS supply shifts inwards
. AD demand decreases due to less consumption after increase in price
Explain ‘ Anticipated Inflation can create inflation spirals’
Cost of Inflation
. If inflation is anticipated, workers will demand higher wages to compensate for the fall in their purchasing power
. This will increase the cost of production for firms, who will transfer this into higher prices leading to even more inflation
. This will also decrease AD, since consumption will decrease
. Additionally, an increase in the cost of production results in an inward shift in the SRAS curve
Explain ‘ Fiscal Drag’
Cost of Inflation
. This is where workers receive a pay increase that matches inflation, but which pushes them into a higher income tax band in a progressive tax system that is not adjusted for inflation
. The individual is not better off with this pay increase and now they have to pay a higher marginal rate of income tax making them worse of than before
. This is unfair and can reduce the incentive for individuals to earn higher incomes if tax band adjusted in accordance with inflation
. This can lead to a reduction in consumption, decreasing AD
Explain ‘Reduce International Competitiveness’
Cost of Inflation
. As inflation increases, the competitiveness of domestic exports decreases, reducing the demand and revenues generated from them
. Furthermore, imports become more competitive, increasing the demand for and and expenditure on them
. Both of these effects worsen the current account in the economy, reducing the value of (X-M) in AD equation decreasing economic growth
. It also shifts AD inwards
Name the benefits of Inflation
. Workers receive increase in pay
. Encourages firms to produce more output
. Provides flexibility to firms
. Results in immediate consumption to utilize purchasing power
Explain ‘Encourages firms to produce more output’
Benefit of inflation
. Inflation can be beneficial if it low and stable and if its caused by demand pull inflation
. Regular inflation encourages firms to produce more output knowing they can increase their revenues and profits
. Inflation also encourages consumers to buy goods and services immediately rather than delaying, in case of higher prices.
. This keep economic growth high.
Explain ‘Workers receive increases in their pay’
Benefit of inflation
Most workers receive pay increase even if the increase only matches inflation
Pay rises can keep productivity high and maintains a high level of consumer spending in the economy. There is also a psychological impact of receiving a pay rise
Explain ‘ Provide Flexibility to Firms’
Benefit of Inflation
. During a RECESSION, inflation provides flexibility to firms who wants to maintain profit but also maintain their workforce size
. Firms can increase prices accordingly to inflation but increase wages by less that inflation, this allowing revenues to rise more than costs
. This maintains profits without having to let go of trained workers
Name Negatives of Deflation
. Delayed Spending
. Deflation increase the real value of debt
. Real Interest rates during deflation always positive
Explain ‘ Delayed Spending’
Cost of Deflation
. Deflation can be the result of a lack of aggregate demand to the economy. It can occur when aggregate supply is higher than aggregate demand
. With price falling in the economy, households may expect further price falling, resulting in delayed spending
. Businesses will reduce their prices further to try increase demand, which will lead to increased deflation and further delay in spending
. This reduces AD, shifting the AD curve inwards
. Additionally, unemployment rises due to decrease in AD
Explain ‘real interest rates during periods of deflation are always positive’
Cost of Deflation
Econplusdal read
Explain ‘deflation will increase the real value of debt’
Econplusdal read
Explain the ONLY positive of deflation
. Deflation is not always bad for the economy if generated from the supply side (cost - push inflation), perhaps as a result of falling petrol or food prices
. It will provide short term relief, increasing spending power in the short term for consumers and relieving cost pressures on businesses
