Question

Identify and explain the costs of inflation. For each cost you identify, carefully and thoroughly explain the exact sense in which it reflects the fundamental principle you identified.

Answer 1

1. Inflation decreases the competitiveness of the export. When an economy experiences high inflation the general price level in the economy for the goods and services increases this decreases the exports from the economy and increases the demand for foreign goods by the domestic consumers. A fall in the net exports creates and trade in balance for a trade deficit for the economy thereby affecting its exchange rate.

2. Inflation affects the exchange rate of an economy. The country experiencing high level of inflation usually finds its currency depreciating because there is a greater demand for foreign goods and hence the demand for foreign currency. Also a fall in the trade surplus or increase in trade deficit leads to an depreciation of the currency.

3. Reduction in the real income level of household- due to increasing price level with the nominal wages fixed the real wages for the households or workers decreases thereby reducing the purchasing power of the households. This leads to lower consumption and hence lower aggregate demand in the economy leading to a cut down in the production and hence GDP.