Consequences of Inflation

Reduces purchasing power  Definition – The amount of goods and services that can be bought with a fixed amount of money.  If incomes rise faster than prices this may not be a problem.

Reduces the value of savings  If inflation is higher than interest rates, people will experience an overall loss in the value of their savings.

Increased business costs  If there is inflation, it generally means businesses have to pay more for resources.  Businesses can pass this cost on to consumers but only if the market is not highly competitive.

Increased business costs  Workers will demand more money if there is a sustained period of inflation.  This is because their wages are not purchasing what they used to.  Workers may be tempted to go on strike.

COLA  Employment contracts, pension benefits, and government entitlements (such as Social Security) can be tied to a cost-of- living index, typically to the Consumer Price Index (CPI). A Cost of Living Allowance (COLA) adjusts salaries based on changes in a cost-of-living index.

Increased business costs  Firms may have to change their price lists or menu costs.  Firms may have to spend more time looking for lower prices. This involves looking around or shoe leather costs.

Balance of payments problems  If inflation is high in one country, that country may have difficulty selling their products in markets abroad.  The price of those exports may be affected by inflation.  Demand for exports will likely fall.

Balance of payments problems  This will have a negative effect on the current account.  Current account- Part of the balance of payments where imports and exports are recorded.  If exports go down and imports go up, this could lead to an even larger current account deficit.

Increases in government spending  When prices rise, the government has to spend more money.  A lot of government spending is linked to inflation.  Index linking- Where certain government payments are linked to an increase in RPI or CPI.

Increases in government spending  What government payments may be Index Linked?

THE FUNCTIONS OF MONEY

The Functions of Money  Medium of exchange- It can be exchanged for goods and services.  This is generally more efficient than a pure barter system.  In a barter system there must be a coincidence of wants before two people can trade – one must want exactly what the other has to offer.

The Functions of Money  Store of value- Money itself has value. It is simple to store value in this form.  This may encourage people to save, depending on the interest rate.

The Functions of Money  Unit of account- Money is used to measure the value of goods and services.  This makes it easy to compare the value of goods and services to each other.

The Functions of Money  Standard for deferred payments- This is basically buying something on credit.  The payment for that good or service can be deferred or delayed until a different date.

Inflation`s effect on the function of money  Generally these effects are negative.  If money loses its value due to hyperinflation, it may lose its value as a medium of exchange.

Inflation`s effect on the function of money  If inflation is high, money will not be a very good store of value.  If inflation is high, the value of certain goods and services may become distorted.

Inflation`s effect on the function of money  Can inflation benefit those in debt?