Inflation

Question 1

What are the 9 costs of inflation?

Answer 1

1. Real wages (nominal wage / price)
   
   2. Low income households are less able to protect themselves
   3. Fiscal drag or bracket creep
   4. Distortion of savings and borrowing
   5. Blurring of price signals leads to poor quality decision making
   6. Investment is attracted into less productive assets, especially real estate
   7. Less incentive to innovate
   8. Devaluation of the currency
   9. Shoe leather or menu costs

Question 2

What are the costs of inflation for Real wages (nominal wage / price)?

Answer 2

a. (w/p) real wages reduce over time as inflation erodes spending power. Nominal wages are only adjusted from time to time
b. (w/p) as p go ups, w stays the same
Same applies to other income forms (e.g. welfare payments)

Question 3

What are the costs of inflation Low income households are less able to protect themselves ?

Answer 3

a. Food and fuel typically make up a larger share of their budget/ basket , these things are often more prone to inflation
b. They don’t have the same substitution opportunities as higher income households (already buying the cheapest form of g/s)

Question 4

What are the costs of inflation for Fiscal drag or bracket creep?

Answer 4

a. In taxation, workers get pushed up tax brackets as nominal wages rise with inflation which raises average tax rates - they are paying higher taxes than they really should
i. (government may be slow, they earn more revenue)
Can also occur with other non indexed thresholds - i.e. student allowances (parental incomes may increase in nominal terms but not real terms), legal aid

Question 5

What are costs of inflation for Distortion of savings and borrowing?

Answer 5

a. Inflation messes up real interest rates: Nominal interest rate less tax THEN less inflation = real interest rate
b. Transfer of wealth from savers to borrowers, as real interest rates fall

Question 6

what are the costs of inflation for Investment is attracted into less productive assets, especially real estate?

Answer 6

Money goes where people feel safest, however housing doesn’t help us grow the economy, and it is hard to extract from housing

Question 7

Why is there a general agreement the target should be “small and positive”?

Answer 7

because:
· A deflationary spiral is also harmful (i.e. great depression)
· A Laspeyres base weighted CPI slightly overstates inflation
· A small amount of inflation can “grease the wheels” of economic adjustment when nominal variables are sticky

Question 8

How does the economy adjust?

Answer 8

Nominal wages are sticky downwards
But even a small amount of inflation greases the wheels of adjustment by allowing real variables to change

If nominal wages rise more slowly than inflation, then real wages fall

Question 9

What happens at a higher price level for a given fixed nominal wage (higher inflation than expected)?

Answer 9

• Workers are worse off
  
  • Labour is cheaper (all input costs)
    ○ Hire more labour
  • Therefore provide more output

Higher inflation (than expected) = lower level of unemployment