Consequences of Inflation

Question 1

what are the 2 areas of consequences of effects of inflation

Answer 1

output effects and redistribution effects

Question 2

what are output effects

Answer 2

purchasing power is reduced and investment/output suffer (impacts output, income and employment)

Question 3

what are the 5 output effects

Answer 3

1. real income falls
2. uncertainty
3. capital for labour substitution
4. international competitiveness reduces
5. lack of confidence in money as a store of value

Question 4

explain the output effect of inflation on real income and how interest rates are effected

Answer 4

if prices rises faster than incomes, purchasing power decreases. for example if the inflation rate is 3% this year, the dollar will only have 97% worth of buying power next year
price rise pushes up interest rate - lenders must maintain a margin between true cost of funds and rate at which loan is repayed (it must be positive). for example if interest rate is 7% but inflation was 8%, purhcasing power would fall faster than loan payback so no one will lend

Question 5

explain the output effect of inflation on international competitiveness and describe the relationship between inflation and exchange rate

Answer 5

if aus has higher inflation rates than other major trading countries current account deficit increases (I>X)
- demand for exports fall as prices rise
- imports of overseas products becomes more comp as price falls relative to within country
ongoing inflation = currency depreciation (demand for exports decreases, this makes exports more comp for overseas buyers,
import price rise = inflationary (when currency depreciates)

Question 6

explain the output effect of inflation on increased uncertainty and what is the multiplier effect on exp and income

Answer 6

savings and investment are disccouraged which reduces growth
investment is more risky as future cost and price are uncertain so rate of return is uncertain
increase capital exp risk = lower output and lower employment

Question 7

explain the output effect of inflation on capital for labour substitution

Answer 7

due to price rise, firm replace people with machines so they dont have to give pay raises

Question 8

explain the output effect of inflation on the lack of confidence in money as a store of value

Answer 8

people seek hedges (things to reduce risk) against price rises they expect. they do so by purchasing assets which traditionally increase in value (property, antiques, gold) but this speculative activity can have neg impact on ouptut if it becomes an easier way to create wealth than innovation
inflation will divert resources away from productive activity making g/s to speculative activities

Question 9

what is hyper inflation

Answer 9

rates of inflation above 30% pa could lead to economic collapse if people hoard (speculative) as a result of no confidence in money as a value

Question 10

explain the venezuela case study of hyper inflation:

• how much
• due to…
• caused

Answer 10

283000% in 2019
due to:
political mismanagement: increased money supply to give wage increases to workers to compensate lower earning from oil when price fell in 2000s
caused depreciation of curreny and increased price of imports

Question 11

what is the redistribution effect

Answer 11

the inflation burden does not fall evenly on all sectors. some groups win and other lose

Question 12

what are 4 winners of inflation

Answer 12

1. households that can buy real assets (rise in price with inflation - property)
2. skilled workers (sectors can pass on price increase to worker through wage increase)
3. borrowers (can build assets on borrowed moeny knowing the real vale of repayments will fall overtime-eg home loaners)
4. government revenue increases due to bracket creep

Question 13

what are 4 losers of inflation

Answer 13

1. low income/welfare ppl - living standard fall unless payments are indexed to rise along w prices
2. lenders - lose unless rate of interest is higher than inflation
3. savers - real value of deposit reduces during inflation as they are basically lending money to bank
4. pay as you go taxpayers - inflation causes income to rise to levels where they are liable for higher tax bracket (bracket creep)

Question 14

what is a bracket creep

Answer 14

increased tax liability as a result of increased income or inflation pushing them to higher bracket

Question 15

What can people do if they predict inflation?

Answer 15

redistrubution effects arent as significant
if banks and consumers correctly forecast inflation rate, nominal interest rates on deposits and loans will rise resulting in little real effect
if not anticipated losers and winners emerge