Briefly explain two favourable and two unfavourable impacts of inflation.
The
favourable impacts of inflation
1. Deflation
(a fall in prices – negative inflation) is very harmful. When prices are
falling, people are reluctant to spend money because they feel goods will be
cheaper in the future; therefore they keep delaying purchases. Also, deflation
increases the real value of debt and reduces the disposable income of
individuals who are struggling to pay off their debt. When people take on a
debt like a mortgage, they generally expect an inflation rate of 2% to help
erode the value of debt over time. If this inflation rate of 2% fails to
materialise, their debt burden will be greater than expected. Periods of
deflation caused serious problems for the UK in 1920s, Japan in 1990s and 2000s
and Eurozone in 2010s.
2. Moderate inflation enables adjustment of
wages. It
is argued a moderate rate of inflation makes it easier to adjust relative
wages. For example, it may be difficult to cut nominal wages (workers resent
and resist a nominal wage cut). But, if average wages are rising due to
moderate inflation, it is easier to increase the wages of productive workers;
unproductive workers can have their wages frozen – which is effectively a real
wage cut. If we had zero inflation, we could end up with more real wage unemployment, with
firms unable to cut wages to attract workers.
Inflation is usually
considered to be a problem when the inflation rate rises above 2%. The higher
the inflation, the more serious the problem is. In extreme circumstances, hyper
inflation can wipe away people’s savings and cause great instability, e.g. Germany
1920s, Hungary 1940s, Zimbabwe 2000s. However, in a modern economy, this kind
of hyper inflation is rare. Usually, inflation is accompanied with higher
interest rates, so savers do not see their savings wiped away. However, inflation
can still cause problems.
1. Inflation tends to discourage investment
and long-term economic growth. This is because of the uncertainty and
confusion that is more likely to occur during periods of high inflation. Low
inflation is said to encourage greater stability and encourage firms to take
risks and invest.
2. Inflation can make an economy
uncompetitive.
For example, a relatively higher rate of inflation in Italy can make Italian
exports uncompetitive, leading to lower AD, a current account deficit and lower
economic growth. This is particularly important for countries in the Euro-zone
because they can’t devalue to restore competitiveness.
The favourable impacts of inflation
1. Deflation (a fall in prices – negative inflation) is very harmful. When prices are falling, people are reluctant to spend money because they feel goods will be cheaper in the future; therefore they keep delaying purchases. Also, deflation increases the real value of debt and reduces the disposable income of individuals who are struggling to pay off their debt. When people take on a debt like a mortgage, they generally expect an inflation rate of 2% to help erode the value of debt over time. If this inflation rate of 2% fails to materialise, their debt burden will be greater than expected. Periods of deflation caused serious problems for the UK in 1920s, Japan in 1990s and 2000s and Eurozone in 2010s.
2. Moderate inflation enables adjustment of wages. It is argued a moderate rate of inflation makes it easier to adjust relative wages. For example, it may be difficult to cut nominal wages (workers resent and resist a nominal wage cut). But, if average wages are rising due to moderate inflation, it is easier to increase the wages of productive workers; unproductive workers can have their wages frozen – which is effectively a real wage cut. If we had zero inflation, we could end up with more real wage unemployment, with firms unable to cut wages to attract workers.
Inflation is usually considered to be a problem when the inflation rate rises above 2%. The higher the inflation, the more serious the problem is. In extreme circumstances, hyper inflation can wipe away people’s savings and cause great instability, e.g. Germany 1920s, Hungary 1940s, Zimbabwe 2000s. However, in a modern economy, this kind of hyper inflation is rare. Usually, inflation is accompanied with higher interest rates, so savers do not see their savings wiped away. However, inflation can still cause problems.
1. Inflation tends to discourage investment and long-term economic growth. This is because of the uncertainty and confusion that is more likely to occur during periods of high inflation. Low inflation is said to encourage greater stability and encourage firms to take risks and invest.
2. Inflation can make an economy uncompetitive. For example, a relatively higher rate of inflation in Italy can make Italian exports uncompetitive, leading to lower AD, a current account deficit and lower economic growth. This is particularly important for countries in the Euro-zone because they can’t devalue to restore competitiveness.
