Impacts of inflation
Households
• Inflation affects the distribution of real
income.
• People on fixed incomes suffer as the
purchasing power of their incomes (their
real income) decrease as price levels rise.
• People whose incomes rise faster than the
rate of inflation experience an increase in
their real wage.
Households
• Inflation tends to result in a more unequal
distribution of income as those on lower
incomes find their wages do not rise as
quickly as those on higher incomes.
• In times of high inflation households tend
to purchase real assets (e.g. houses, gold,
antiques, paintings etc) that retain their
real value since their prices rise faster
than the inflation rate.
Households
• As employees nominal wages increase with
inflation their real wage (the purchasing power of
nominal wages) may remain constant.
• Under progressive tax system increased
nominal wages may put wage earners into
higher tax brackets (higher marginal tax rate).
• The percentage on income paid in tax rises even
though real wages remain constant.
• This is called Bracket Creep or Fiscal Drag.
Savers/Borrowers
• Inflation encourages current consumption
(buy goods and services now before
prices rise) and discourages savings.
• People with savings suffer in times of
inflation as the purchasing power of their
savings decreases as price levels rise.
• The real rate of interest (nominal rate less
the inflation rate) is reduced in times of
inflation.
Savers/Borrowers
• Real interest rates may be negative if
inflation rate is greater than the interest
rate. If so the purchasing power of savings
declines. This discourages savings.
• People who have borrowed money benefit
as the real value of loans decreases as
price levels rise (loans are easier to repay
in the future as prices and income rise
over time).
Savers/Borrowers
• Borrowers benefit as inflation reduces the
real value (the purchasing power) of the
money they owe.
• People who have borrowed money benefit
as the real value of loans decreases as
price levels rise (loans are easier to repay
in the future as prices and income rise
over time).
Firms
• Since inflation reduces the incentive for
households to save, it causes a shortage
of savings for firms to borrow.
• Firms finance investment (the purchase of
new capital goods) by borrowing money. If
there is no savings funds for investment
will be limited.
Firms
• Inflation reduces business confidence and
increases uncertainty, which reduces levels of
investment.
• Reduced levels of investment negatively impact
on future production and employment levels.
• If rising costs of production caused by inflation
(workers demand higher wages to compensate
for inflation) cannot be passed on to consumers
then firms profits will be reduced.
Firms
• Costs of production will rise as interests
repayments, power, rent, etc become
more expensive and workers demand
higher wages to compensate for inflation.,
• If rising costs of production caused by
inflation cannot be passed on to
consumers then firms profits will be
reduced.
Trade
• If inflation in New Zealand is higher than in our
trading partners then NZ goods become less
competitive overseas (relatively more
expensive). Levels of exports may decline.
• Imports into NZ will become relatively cheaper
as prices of NZ made goods rise. Demand for
local products will fall, decreasing employment
levels.
• This has a negative impact on NZ’s balance of
payemnts.
Growth and Employment
• High levels of inflation reduce confidence and
increase uncertainty (difficult to ptredict the
future).
• This reduces investment, increases levels of
imports, reduces exports, depreciates the value
of the local currency, increases unemployment
and reduces economic growth.
• Increasing prices together with rising
unemployment is referred to as “stagflation”.
Market efficiency
• Inflation distorts the price signals to the
market and causes inefficient allocation of
resources.
• Resources are often allocated to
speculative assets (precious metals,
shares on the stock market, antiques etc)
whose nominal value rises with inflation,
but do not add to the levels of output and
employment in a country.