Question

The importance of inflation resides ultimately in its overall effects on the standard of living of a people. Discuss

Answer 1

Inflation is defined as the rate of change in prices compared to the previous year.

It erodes in the purchasing power of the individual. For example, a basket of good purchased in a sum of amount would cost higher sum of amount for the same basket of good the subsequent year. Thus, it pushes the prices up.

Hence, an individual needs to spend more to maintain the same standard of living. Greater spending have a larger benefit to the economy as more money is used in consumption and investment. Thus, savings are limited.

Hence, an individual is required to earn more and make more money. Thus, inflation incentivizes spending in the economy and deters savings if the rise in income is not greater of equivalent to the rise in inflation. For example, a retired person living on fixed income instruments will have a negative impact as his income is fixed and inflation is slowing decreasing his purchasing power as real income is negative. Only with people who make money at a rate greater than the inflation are benefitted in real terms and their standard of living is better off.

Hence, central bank pushes the interest rate higher when the inflation is high to balance employment growth and adjust against the new value of currency after inflation.

Thus, the standard of living is affect by inflation and also neutralized by the central banks by raising the interest rates. This cycle is important for an expansionary economy.