Transcript Effects of Inflation

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 = The amount of goods
and services which can be purchased by a
person’s income
• 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.
Prices increase which results in a higher cost of living
Impacts of Inflation on
Households
Savers ------ LOSE
• Inflation creates a disincentive to save, people are more
likely to spend money now before prices increases
• Inflation erodes the real value of savings i.e. your savings
buy less goods and services than they did before.
[Note: interest rates compensate for this but your real
return is still reduced e.g. if interest rate on savings is 6%
then your savings are increasing in value by 6% but if
inflation is 4% then your savings are decreasing in value by
4%. Overall your real return is 2%]
• Real interest rate = the nominal interest
rate – inflation rate
Impacts of Inflation on
Households
Borrowers: WIN
• Inflation creates an incentive to borrow as
borrowers pay back less in real terms
– i.e. the dollars which are repaid buy less goods and
services than before .
• As assets increase in price during times of
inflation people can borrow more against the
asset
– i.e. if banks let you borrow 80% of the value of your
home then if the value of your home increases then
you can borrow more money.
Impacts of Inflation on
Households
Borrowers: WIN [continued]
• Leverage - the amount borrowed as a percentage
of the value of an asset falls if the asset increases
in price/value due to inflation
e.g. buy a house for $500 000 and borrow $400
000 to finance it [ loan = 80% of the house value].
Over the next 5 years The value of the house
rises to $600 000 due to inflation. The original
amount of the loan is now only 66.67% of the
house value
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
• Real Income = Income adjusted for
inflation. Income in terms of what it can
buy.
• Nominal Income = A persons income in
monetary terms.
Impacts of Inflation on
Households
Fixed Income Earners: LOSE
• Their income falls in real terms
– i.e their income stays the same as prices rise so their
income buys less.
This especially affects those people on benefits
such as the unemployment benefit or
superannuation.
Impacts of Inflation on
Households
Incomes that rise faster than inflation: WIN
• Those people who get paid commission
based on the value of what they sell may find
their income increases as prices/values
increase.
• Also people whose skills are in high demand
or who are members of strong unions may be
able to demand larger pay increases.
Impacts of Inflation on
Households
Fiscal Drag: LOSE
• As people’s income tend to increase during
inflation they move into a higher marginal
income tax bracket – meaning they pay a higher
tax rate.
Impacts of Inflation on
Households
Planning/Budgeting: LOSE
• More difficult to budget for day to day
living expenses or plan ahead to buy
assets such as houses because it is more
difficult to know what prices will be in the
future.
Impacts of Inflation on
Households
Holders of Real Wealth: WIN
• The value of assets such as houses tends to
keep pace or rise more than the inflation rate.
Asset owners benefit from a rise in wealth
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.
Workbook page 45-46
Impact of Inflation
on Firms
Increase cost of resources LOSE
• Inflation forces up firm’s production costs.
– Increased costs of resources
• Resources cost more to buy therefore profits will go 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.
Investment LOSE
• Investment = Purchases of capital equipment
• Capital equipment = Man made goods used to produce other
goods and services. E.g. Hammer, computer, printer, tractor
• Inflation causes prices of factories, machinery and vehicles etc.
to rise so it is more expensive for firms to expand.
• Inflation causes business confidence to fall and discourages
investment as higher returns are needed to compensate for
inflation and so investment is seen as a higher risk.
Planning: LOSE
• Makes planning more difficult as future costs
and prices are harder to predict if they are
increasing.
.
Investment Loans -Borrowing:
WIN
• Inflation encourages debt as the amount you
have to pay back falls in real terms.
• This makes investment loans cheaper as real
amount borrowed falls.
• Can borrow more against value of firm’s assets
Speculation
Speculation: Buying goods/resources now as you
believe the price will rise in the future.
• Businesses are more likely to speculate on non
productive assets that are likely to increase in price
quickly during times of inflation e.g. buying sections
of land
Exporters: LOSE
• 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).by an
increase in prices which means NZ exports are less price
competitive overseas leading to less demand from
overseas and a fall in exports.
• Producers may decide to leave overseas price unchanged
and take a cut in profits in order to remain competitive.
Importers:
WIN
• Imports become more price competitive. If NZ’s
inflation rate is higher than other countries we
trade with then the price of imported goods rises
less than the price of NZ goods so they become
more price competitive.
Workbooks page 47-48
Impact of Inflation on
Government
Government Spending e.g.
• Rising costs/prices means Govt. will have to
spend more on health, education, police etc.
• Beneficiaries may demand benefit increases to
offset the the fall in real income/purchasing power.
Government Income e.g.
• Increased spending due to higher
prices/inflationary expectations will increase GST
revenue.
• Rising incomes will mean more people in higher
income tax brackets so more income tax revenue.
Impact of Inflation on
Government
Operating Balance
• Increased Government spending has a negative
effect on the operating balance
• Increased tax take through GST and income tax
will have a positive effect on the Government
operating balance
• Overall effect of inflation on the operating
balance depends if the positive effect of
increased tax is greater or less than the
negative effect of increased spending.