5) Inflation 3 - MB

Question 1

What are the 6 consequences of persistently high inflation?

Answer 1

1) increased inequality
2) falling real incomes
3) resource allocation
4) risks of wage inflation
5) uncertainty
6) menu and shoe-leather costs

Question 2

How does persistently high inflation cause an increase in inequality?

Answer 2

In lower income households, most wealth is held in cash and money

Question 3

How does persistently high inflation cause falling real incomes?

Answer 3

Wages rises often lag behind substantial price increases, leads to industrial unrest, strikes and walkouts

Question 4

How does persistently high inflation cause a difference in resource allocation?

Answer 4

Price signals become less clear, leading to wastage of resources and lost business opportunities

Question 5

How does persistently high inflation cause risks of wage inflation?

Answer 5

As workers negotiate higher wages, costs are increased for firms, which may reinforce the inflationary process

Question 6

How does persistently high inflation cause uncertainty?

Answer 6

Businesses become less confident about future costs and prices, and consequently may reduce their investment

Question 7

How does persistently high inflation cause menu and shoe-leather costs?

Answer 7

This means that firms must update their price lists more often, raising costs (menu costs). Also if real interest rates are negative, the opportunity cost of holding money is high. This can be somewhat mitigated by more frequent trips to bank money so that it earns interest. The opportunity cost of this action is called “shoe-leather costs”

Question 8

What’s the difference between the way high income households and low income households store their money?

Answer 8

High income households invest in assets like property and financial . These hold their value far better than money. Low income households hold a greater proportion of their wealth in money. Inflation means that the real value of money is lower. Inflation increases inequality by increasing the wealth of wealthy households, but decreasing the wealth of poorer households

Question 9

What is a result of falling real incomes due to high inflation?

Answer 9

If inflation is higher than wage increases, then real incomes are falling. This means that consumers and households are experiencing a lower standard of living because they can afford to buy fewer goods and services

Question 10

What do negative real interest rates lead to?

Answer 10

Lead to distortions in the price mechanisms of the economy. Conventional saving of putting money in a bank account leads to falling real value of savings. Instead, consumers choose to spend, taking risky investments, buy extra property etc

Question 11

How could high inflation possibly lead to a wage-price spiral?

Answer 11

As increased inflation leads to workers to demand higher wages, firms are forced to increase prices to cover the cost of these increased wages. This leads to inflation, and the cycle continues making inflation self-perpetuating

Question 12

Why do businesses postpone much of their investment due to high inflation?

Answer 12

Inflation leads to uncertainty about future prices and profitability of investment, this causes businesses to postpone much of their investment, hindering economic growth

Question 13

Why does competitiveness of exports suffer due to high inflation?

Answer 13

-if domestic inflation is higher than inflation in export markets, the competitiveness of exports differs as UK prices become relatively more expensive - further curtailing AD as part of net exports, and future AD and AS via reduced investment

Question 14

Business investment increases both…

Answer 14

AD and AS, increasing both short run economic growth and long run economic growth

Question 15

What are the advantages of high inflation? 2 things

Answer 15

1) reduced real value of debt
2) facilitates economic growth

Question 16

How does inflation reduce real value of debt?

Answer 16

The largest borrower, the government, benefits from high inflation as it erodes the real value of its debt, making it more affordable

Question 17

How does inflation facilitate economic growth?

Answer 17

Low and stable inflation around 2% is beneficial as it does not hinder investment, spending and saving. Inflation that is much higher or lower hinders all these things

Question 18

What are the 4 disadvantages of inflation?

Answer 18

1) fiscal drag
2) increased costs
3) uncertainty
4) reduce the confidence of external investors in an economy

Question 19

How does inflation cause fiscal drag?

Answer 19

The government may not increase tax brackets at the same rate as inflation, increasing tax rates on income that is worth less

Question 20

How does inflation increase costs?

Answer 20

Menu costs can be mitigated with digital pricing, but due to lack of investment many sectors, such as supermarkets, have not invested in this - unlike in the EU. The rise of contactless payments has reduced shoe-leather costs, but having to search longer for the best prices is an unproductive use of households’ and business’ time

Question 21

How can inflation lead to uncertainty?

Answer 21

Increased uncertainty for businesses may be the most important disadvantage or very high or negative inflation as, uniquely, it tends to impeded short run economic growth and long run economic growth

Question 22

Judgements: is high inflation desirable?

Answer 22

What the economic objectives are; if the objective is to reduce national debt, then high inflation can be desirable. But if the objective is economic growth, then low and stable inflation is most beneficial

Question 23

how is FDI negatively affected?

Answer 23

as foreign investors think the UK is too expensive. The government finds it harder to borrow money as lenders demand much higher rates to cover their uncertainty