Is Inflation desirable? Depends on: 1) Degree of inflation: Mild or Severe? 2) Time period under consideration: SR or LR? 3) Anticipated or Unanticipated?

Introduction Step 1: Define Inflation Inflation refers to the sustained increase in general price level. Step 2: State the determinants of the desirability of inflation Whether inflation will results in positive or negative effects depends on the degree of inflation, that is, whether it is just mild inflation or severe inflation; the time period under consideration: are we looking at the short-run effect or long-run effect; as well as whether the inflation is anticipated or unanticipated. Development Step 3: Explain effects of anticipated inflation Generally, inflation that is anticipated is more manageable than unanticipated inflation as indexation that increases a nominal costs can be used to prevent inflation from eroding purchasing power. Nevertheless, economists still identify 2 main adverse effects of anticipated inflation. They are menu costs and shoe-leather costs. The former refers to the cost to firms and restaurants for constantly having to revise price lists, labels and catalogues due to the continuous increase in general price level. Shoe-leather costs are costs firms incur in moving money in and out of financial institutions in search of the highest returns. As inflation rate continues to surge, firms want to ensure that their investment generates a high returns to counter the fall in money value. Step 4: Explain effects of unanticipated inflation Define unanticipated inflation Unanticipated inflation occurs when economic agents make errors in their inflation forecasts where actual inflation may end up higher or lower than expected. This impose extra costs on individuals where their real incomes and savings may fall as well as businesses who misjudge the real return on capital investment projects and who find it difficult to predict what is likely to happen to their costs. Thesis: Desirable (Positive effect): Internal effect on Production, Investment & Employment (SR) A mild demand-pull inflation can be beneficial to an economy in the short-run. It stimulates production and output due to the prospect of earning higher profits. In the short-run, when increase 1

in production costs lags behind increase in product prices (due to imperfect information and contract obligations), business activities will be stimulated as profit margins widen. In addition, with expectation of higher profit margins than before, businesses are more willing to invest. Thus, in the short-run, investment is likely to increase in the period of rising prices. With increased production and investment, this result in an increase in AD, assuming other components of AD remains unchanged. Assuming the economy is operating with spare resources, this rise in AD results in an increase in NY as well as rise in employment rate. Anti-Thesis: Undesirable (Adverse) Internal effect on Production, Investment & Employment (LR) However, in the long-run, production, national income and employment rate will fall when the cost of production also rises, narrowing the profit margins which lead to businesses reducing their AS. In the long-run, as firms begin to demand more of these raw materials to produce more goods to meet the increasing demand, prices of such raw materials also rise. In addition, in the long-run when contracts expires, new contracts drawn will be based on new current prices that reflects the rising prices. Also, due to the higher cost of living, workers will bargain for higher nominal wages in order to keep real wages unchanged. Assuming employers oblige, this rise in labour costs further increases the cost of production. Firms that cannot pass on the higher costs to consumers in the form of higher prices will have to absorb the higher factor costs. All the above lowers the profit margins of firms. Firms react to this by reducing their AS. This shifts the SRAS curve to the left, causing a fall in production, employment and national income. In addition, when inflation continues to climb, uncertainty arises, making it difficult for firms to predict future streams of costs and revenues. Producers will also lose confident with the high and uncertain inflation rate and therefore be less willing to produce or invest. Firms will cut back expenditure on capital goods such as machinery and plants. This results in a fall in Investment leading to a fall in AD which in turn has adverse repercussions on the employment and income level. (Adverse) Internal effect on Savings With rising prices, the value of money falls. Savings in real terms decline hence people will be discouraged from savings. This leads to a fall in savings. With a fall in savings, less fund will be available to loan out for investment. Wealth in other less liquid forms such as buying real estates would be preferred since prices of it will most likely rise and hence wealth will also rise. (Adverse) Internal effect on Redistribution of Income & Wealth Inflation worsens income distribution as it creates inequity among the different groups of people in the economy. Inflation redistributes income away from creditors to debtors. Debtors gain while creditors lose because debts are expressed in terms of fixed monetary units. As prices rise, value of money falls. This results in a fall in the real value of debt during inflation. Thus, the purchasing power of the money repaid by the debtor is less than the purchasing power of the initial amount borrowed.

Inflation also redistributes income away from those on fixed incomes to employers of such workers. Fixed income earners have less purchasing power during inflation as the same amount of salary now can get them less goods. On the other hand, employers of such workers now pay less in terms of real value of the salary. In the short-run, entrepreneurs and shareholders benefit as their incomes respond quickly and in the same direction as the changes in prices. Initially, as product prices go up, producer s profits and income raises because product prices rise faster than production costs in the short-run during mild demand-pull inflation, hence raising their profits and redistribute income from consumers to producers. However, in the long-run, the redistribution may not be so apparent when production costs catch up with the rise in product prices. Producer s income may fall unless they pass the rise in COP to consumers. (Adverse) Internal effects on Social Discontentment Due to the unequal income distribution, internal social discontentment may result. Escalating costs of living is also a cause for social discontentment. The standard of living might fall since wages tend to increase slower than the rise in prices because wages have been fixed on a contract basis and take some time to be revised. If inflation is serious and persists too long, poverty might result. (Adverse) External effects of BOP During inflation, balance of trade worsens and may also adversely affect balance of trade payment, assuming the capital account remains unchanged. During inflation, the price of the country s exports would be higher relative to the exports of other countries, hence causing quantity demanded of exports to fall. Assuming demand for exports to be price elastic, this would lead to a more than proportionate fall in quantity demanded, hence resulting in a fall in export revenue as the country s exports become less price competitive. In addition, demand for imports rises as prices of imports become relatively cheaper compared with locally-produced substitutes. Assuming that imports and locally produced products are close substitutes, the rise in price of products leads to a more than proportionate increase in the quantity demanded of imports. Import expenditure rises. With the fall in export revenue and rise in import expenditure, the country s BOT worsens. In the case of high degree of inflation, the economy will be unattractive to foreign investors since costs are escalating, causing production to be uncompetitive. Firms will not be willing to invest and existing firms may choose to relocate their production to other low cost countries. This outflow of foreign direct investment will lead to a long-term capital outflow, worsening capital account. Hence, the worsening of both current account (BOT) and capital account will have adverse effect of the country s balance of payments. (Adverse) Loss of Confidence in Future Value of Currency (External effect of ER)

When balance of payment worsens due to high degree of inflation, external value of the country s currency will also fall, ceteris paribus. As mentioned earlier, price of the country s exports rises, leading to a more than proportionate fall in quantity demanded of its exports, demand for the country s currency fall as a result. In addition, as price of imports is now relatively cheaper, quantity demanded of imports rise more than proportionate, resulting in an increase in the supply of the country s currency as they sell it to buy foreign currency to pay for imports. The fall in demand with a concurrent rise in supply of currency results in a fall in its exchange rate. This may in turn cause an outflow of hot money and puts further pressure on the BOP and exchange rate as investors lose confidence in the future value of the currency. Conclusion Therefore, inflation is desirable in the short-run provided that degree of inflation is mild as it leads to economic growth. However, it is important to note that if it persists or worsens, inflation is undesirable as it creates conflicts to the other macro goals of the country.