Effects of Inflation
• explain the effects of inflation on
households and firms
• explain the effects of inflation on
growth and trade
Inflation and Households
• Purchasing power:
– Inflation reduces purchasing power (get less for same
price).
• i.e. family on an income = $100/week, they buy one product
worth $5. This means they can purchase 20 of this good. But
if the price were to increase to $10 for the product they could
now only purchase 10.
– Standard of living has declined.
– If a households income increases with inflation then
the price increases will not hurt their purchasing
power. Fixed income households will suffer a
decrease in purchasing power.
Inflation and Households
• Inflationary expectations:
– When we expect inflation to
occur, we buy goods and
services before we normally
would to beat the price rise,
but instead help cause
inflation.
Inflation and households
• To control inflation the RBNZ may rise the
OCR. This leads to interest rates
increasing, and in turn decreasing
consumer spending…..
Interest Rates and Households
• Interest rates are the price of money: savers
receive interest as the price paid to them by
borrowers for the use of their money.
• Increase in interest rates:
– cost of borrowing increases which will discourage
consumers from purchasing goods and services on
credit (loan, mortgage, credit card, hire purchase)
therefore consumption will decrease.
– Increase in return from savings which will encourage
people to save, therefore consumption will decrease.
I would like to
borrow $100
please Mr
Krabs, to buy
Gary a new
bed
meow
Ok, I will lend you
$100 but in one
year you must
pay back 6%
interest
MEANWHILE
Prices in
bikini bottom
are rising at
10%!
Who will be better
off in a years time,
Mr Krabs or
Spongbob?
Here’s your
$106 Mr
Krabs
But…. Prices have rose
by !0%, if I wanted to buy
a new cash register a
year ago I would only
have to pay
$100, now I have to pay
$110
Inflation and Borrowers vs. Lenders
• Borrowers will become better off in times when the
inflation rate is more than the nominal interest
rate.
– Example: say you borrow $100 at an interest rate of 6%
at a time when prices are rising at a rate of 10%. In one
years time you will repay $106.
– The lender receives this back, but if they (the lender)
wanted to buy the same good you bought for $100 a
year ago they must now pay $110 for it (due to 10%
inflation) and so cannot afford it now. They could have
afforded it at the time you borrowed the money.
– The real rate of interest would be -4% (the nominal
interest rate – inflation = real interest rate). Therefore
making savers worse off than borrowers.
Interest Rates and Households
• Decrease in interest rates:
– Cost of borrowing decreases which will
encourage people to purchase more goods
and services on credit, therefore consumption
will increase.
– Decrease in return from savings which will
discourage people to save, therefore
consumption will increase.
Firms and Inflation
• Firms also get hit by inflation:
– Increased costs of resources
• Resources cost more to buy
profits down.
– E.g. materials, fuel.
– Firms will either pass increased costs to
consumers by increasing price (which can
cause a decrease in demand for their product)
OR they will keep the price the same and
decrease their profits.
Firms and Inflation
– Increased demand for wage rises
• Firms will feel pressure from unions to pay higher
wages if inflation continues to exist.
• This reduces their profits and may cause
redundancies.
Double hit to firms
• The RBNZ will try and minimise the effects
of inflations and will increase the OCR
causing higher interest rates (more
expensive to invest by firms).
• Higher interest rates attract Foreign
Investment to NZ.
• This increases the demand for the $NZ,
therefore appreciation of the $NZ.
• Export receipts will drop as it becomes
more expensive for overseas consumers
to buy our exports.
• Imported raw materials become relatively
cheaper
Growth and Inflation
• Growth is an increased amount of GDP
being produced each year.
– GDP= AD = C + I + G + (X – M)
– If the horizontal axis on our AD/AS model
changes this effects NZ Growth.
– How will inflation effect Growth???
Trade and Inflation
• Inflation pushes NZ costs of production up
– E.g. a good that costs $100 to make will soon cost
$110 to make.
• The higher costs of production will then usually
be passed onto consumers (our international
trading partners).
• Our goods become relatively more expensive
compared to our international competitors,
therefore we lose out international
competitiveness. X decreases (decreasing net
exports).
• Imports now become relatively cheaper so M will
increase (decreasing net exports).
• Planning:
• http://tutor2u.net/economics/content/topics
/inflation/costs_of_inflation.htm
• http://everything2.com/title/The%2520effec
ts%2520of%2520inflation