Consequences of Inflation

Why does inflation matter?

 The impact of inflation on individuals and businesses is different depending on if the inflation is anticipated or unanticipated:

Anticipated inflation: This is when people are able to make accurate predictions of inflation, so they take steps to protect themselves from its negative effects. For example, Individuals may switch savings into deposit accounts that offers a high nominal rate of interest. People do this so they can protect the real value of their financial wealth. Furthermore, firms can adjust prices and banks can adjust interest rates.

Unanticipated inflation: This occurs when inflation is very different from year to year; it becomes very difficult for people to correctly predict the rate of inflation in the next year. Unanticipated inflation occurs when people, businesses or governments make errors in predicting the future inflation rate.

The Main Costs of Inflation

The case for maintaining price stability

 People must be very careful to distinguish different degrees of inflation. Individuals and businesses also have to be more aware that inflation will have different effects on individuals and the economy as a whole.

Impact of Inflation on Savers

 Inflation leads to an increase in general prices causing money to lose its original value. When inflation rates are high, people may lose confidence in money as the real value of their money is greatly reduced. Savers will also stop saving money if nominal interest rates are lower than inflation rates. For example, a person may receive a 2.5% nominal rate of interest on his savings account, but if the annual rate of inflation is 4%, then the real rate of interest on savings is -1.5%.

Inflation Expectations and Wage Demands

 Inflation may get out of control when price increase leads to higher wage demands as people try to maintain their living standards.  Many companies then increase prices to maintain.   

Arbitrary Re-Distributions of Income

 Inflation tends to hurt those employees in jobs with low paid jobs and little or no trade union protection. Inflation may also benefit borrowers as inflation decreases the real value of existing debts. This is called Arbitrary Re-Distributions of Income.

Business Planning and Investment

 Inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflations of both prices and costs. Lower investment then has a negative effect on the economy’s long run growth potential.

Competitiveness and Unemployment

 Inflation causes higher unemployment in the medium term if a country experiences a much higher rate of inflation than another, leading to a loss of international competition. If inflation in the Taiwan is above its major trading partners, then the international companies in Taiwan will begin to struggle to maintain its oversea shares.

Causes of Inflation

Cost Push Inflation

When businesses respond to rising production costs, by raising prices in order to maintain their profit margins, cost push inflation occurs. There are many various reasons why costs might rise:

Rising imported raw materials costs caused by inflation occur in countries that are heavily dependent on exported goods

Rising labour costs are caused by the increase of wages which exceed improvement in productivity.  This cause is very important in industries which are labour-intensive. 

Higher indirect taxes imposed by the government  E.g. a rise in the taxes  on alcohol and cigarettes. These taxes are levied on producers  who depend on the price elasticity of demand and supply for their products. For example, if the government was to choose to add a new tax on car fuel, this would lead to a rise in cost-push inflation.

Demand Pull Inflation

 Demand pull inflation is the inflation resulting from an increase in aggregate demand is called demand-pull inflation. Aggregtate demand is the sum of all demand in an economy. The main aggregated demand that generate ongoing increases in aggregate demand are:

-Increases in the money supply

-Increases in government purchases

-Increases in the price level in the world