Book 10C - Effects of inflation (Ignore for now)

Inflation leads to random redistribution of income depending on whether a person is a…

1. Fixed VS variable income earner

2. Savers VS borrower 

3. Government VS taxpayer 

Compare effects of inflation on fixed VS variable income earner

1. Fixed:

• Fixed in nominal terms -> real income falls -> lose during inflation (Eg. Retirees, welfare recipients) -> fall in PP 

2. Variable:

• Earn a higher income during times of high rates of inflation as their income is calculated typically as a percentage of their sales revenue generated as commissions (Eg. Car salesman) 

• If workers’ annual nominal wage increases more quickly than the general price level -> real wages increase (likely workers who belong to trade unions with strong bargaining power) 

• This will lead to an unfair distribution of goods and services in society as the variable income earners are able to continue to consume goods and services

Compare effects of inflation on savers VS borrowers

• Inflation ->  borrower (debtors) gain and savers (creditor/lenders) lose

• Loans are charged at a nominal interest rate set at the start

• Real interest rate = Nominal interest rate – Inflation rate

• If inflation > nominal interest rate -> real interest rate becomes negative → lenders receive less in real terms than expected

• Borrowers pay back debt in money that’s worth less, benefiting them.

• The real value of debt and interest paid by the borrower to the lender will be lower than expected -> lower purchasing power -> savers lose our 

• This causes arbitrary redistribution of income: Among households (savers vs. borrowers), between households and firms and between households and government

Compare effects of inflation on government VS taxpayer

• Inflation triggers a wage-price spiral: workers demand higher nominal wages to keep up with rising prices

• With a progressive tax system, higher nominal wages push taxpayers into higher tax brackets (bracket creep)

• This redistributes wealth: 

  • Government gains via higher tax revenue.

  • Taxpayers lose because real disposable income falls.

Describe profile of savers VS borrowers

• Savers: tend to be old, paid housing loans and built up savings 

• Borrower: young with housing loans

Describe measures to help workers with inflation

• Link wages to the CPI (Consumer Price Index)

• Include a cost-of-living allowance (COLA) clause in contracts.

• When prices rise, nominal wages automatically rise -> keep real wages stable despite inflation

Describe measures to help creditors with inflation

1. Creditors (Debt indexation) 

• Debt contracts (tied to CPI) so real interest rate is maintained and real face value of bond (sum borrowed) is maintained -> maintain real value of debt

Describe measures to help taxpayers with inflation

1. Taxpayers (Tax bracket indexation) 

• Nominal tax breakers adjusted automatically in proportion to changes in GPL -> taxes paid based on real income 

• Ability to implement measures depends on whether there are institutions that enable people to adjust to anticipated inflation and bargaining power of parties

State effects of inflation on efficiency

1. No PE

2. Distortion of price mechanism

3. Wastage of resources

Describe effect of inflation on PE

• High inflation would erode PP of cash -> households would have increased incentive to convert their cash into goods, other currencies or other financial assets such as shares, that offer a more stable store of value

• Significant time and effort to manage these money holdings will impose an opportunity cost on workers in terms of less time and effort being channelled to produce G&S -> production levels not maximised -> no PE 

Describe effects of inflation on price mechanism

• When the price of a good is unstable such that a producer is unable to clearly determine if the price increase is indeed due to an underlying increase in consumer preference and increase in demand for that product

• He may choose to allocate more resources to the production of that good, but consumer demand may not have increased.

• Due to scarcity, resources must be allocated in a way which maximises society's welfare to achieve AE 

• In a market economy, price signals play are the mechanism by which this is attained (higher prices indicate rising consumer preference for the good and resources should be allocated to fulfill consumers desire for the good)

• With the distortion of the price mechanism as a result of high and rising inflation, society's welfare will not be maximised.

Describe effect of inflation on wastage of resources

• Menu costs: costs of changing prices (deciding prices, changing price labels) 

• High inflation -> firms change price often to keep up with other prices -> incurring higher menu costs -> wastage of resources as they could have been used for other purposes 

EVALS effects of inflation on wastage of resources

Eval: Depends on anticipated VS unanticipated inflation: 

• Anticipated: economic agents correctly predict future rate of inflation and adjust their behaviour accordingly 

• Even when expected, rising prices impose costs (Eg. menu costs)

Eval: Severity of the effects (or consequences) of inflation depends primarily on the cause of inflation and degree/extent of the inflation