…what if we allowed for hubris to “inflate”? (Chapter 14 Q & A)

28/02/2013 § Leave a comment

#2. 25 marks.

a) What are the costs of a high rate of inflation?

Inflation is an increase in the average price levels of goods and services in a nation over time. If the rate of inflation is less than 2%, the economy could be expecting disinflation and eventually, deflation. The healthy rate of inflation is considered to be 2 – 3%. Inflation rates over 3% are then high and can have negative consequences such as the loss of purchasing power. An increase in inflation can take away from the income of a household. Even if a worker’s income increases, if the inflation right in the economy is higher than that of the worker’s income increase, then they’ve lost much of their purchasing power and have essentially become poorer than they were before the inflation rate increased.

High rates of inflation also lower real interest rates for savers, who are interested in fixed-interest assets, such as government bonds or savings accounts. As inflation rises, the interest rate earned on savings would fall. A high inflation rate also creates higher nominal interest rates for borrowers, meaning that during times of high inflation, banks would raise their nominal interest rates that they charge borrowers – obviously they want to earn more profit and in this case, we could say that inflation rates and interest rates are linked. This means that borrowers pay more, making it more expensive for firms or households to borrow money from banks.

Finally, higher interest rates reduces a nation’s competition with the rest of the global market. High inflation within the country makes the domestic output look far less attractive to foreigners therefore they’d stop importing goods from that domestic country. That nation with the high inflation (hey, that rhymed) would experienced reduced profit from their Exports/Imports sector. Similarly, the high inflation rates would make imports look more attractive to the domestic citizens instead of their own domestic goods.

 

b) “What is wanted is not inflation or deflation but price stability.” Discuss.

We learned that with the Phillips curve comes the NAIRU, or the non-accelerating inflation rate of unemployment. This is the level of unemployment in the economy that works well when the nation is producing at full employment. The key to the NAIRU is that price levels are stable, they are not pressured upwards or downwards. Based on the LRPC and the neoclassicist point of view that, when left alone, an unstable economy will be able to correct itself as the unemployment rate will always be able to move back to its natural rate of unemployment. This is the part of the LRPC that is neither perfectly elastic or inelastic – it’s around in the middle. Straying away from this middle would cause either inflation (a rise in the average price levels) or deflation (a decrease in the average price levels).

We know there are more losing stakeholders than there are winning stakeholders when it comes both inflation and deflation. The winners during times of inflation are borrowers, flexible income earners, and importers, but the losers are the lenders, fixed-income earners, savers, and exporters. The lenders are the ones who received less money the borrowers paid them back because inflation had lowered their interest rates. The fixed-income earners have an overall reduced income and purchasing power. The savers also experience lower interest rates and can’t save as much as they used to. And exporters lose business because other nations won’t buy from them.

The costs to deflation are multiple, including rising unemployment, falling investment, falling consumption and increased savings, and increased debt burden on households. Deflation clearly diminishes the confidence and animal spirit among firms, which plunges the economy into a deflationary spiral that only pushes the AD further back as well as bumping prices lower and lower (as AD moves left – backwards – price moves downwards). Consumption, net exports, investments are all key factors that push the AD back and continue the deflationary spiral.

That being said, since both inflation and deflation can be extremely harmful and costly to an economy, it’s safer to maintain stable prices. For countries that really want to focus on economic growth, they should definitely try and maintain the healthy inflation rate of 2 – 3% but nothing more or less unless they’re willing to experience the negative consequences of deflation or inflation.

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