effects of inflation Flashcards
What is real income and purchasing power
Real income – Your income adjusted for inflation. For real income to increase, your wage has to grow at a faster rate than inflation.
Purchasing power – What you can purchase with your income. If real incomes decrease, so too does purchasing power.
Real incomes of consumers will decrease, and in turn, their purchasing power decreases also. This means that households cannot purchase the same amount of goods and services as they were able to before.
International competitiveness and its impact on the Australian dollar
Over time, as inflation increases, prices in Australia will increase. Ceteris Paribus (all other things remaining the same), this means that overseas competitors will have a price advantage. This will reduce our international competitiveness of our exports such as beef, wheat, iron ore and coal.
At the same time less foreign demand for our goods and services will affect the value of our Australian dollar. It will become weaker and lead to a depreciation.
A depreciation of an Australian dollar, will then make things such as imports from overseas more expensive.
Economic uncertainty
Investments businesses become riskier when decision makers don’t know or cannot predict with confidence prices in the future.
This then leads to less business output long term, which reduces unemployment.
At the same time, high level of inflation makes it challenging for consumers and households to plan for future expenses, save money, or make long-term financial decisions. The uncertainty can reduce consumer confidence, leading to decreased spending and saving, which can further impact the economy.
Interest Rates
Assume inflation is 2%. If the nominal interest rates are 5%, then the real interest rate is 3%. As inflation increases (to lets say 4%), the real interest rate will decrease. This will mean that banks will increase their nominal interest rates to ensure that they continue to make a profit.
