Question

What is inflation?

Name and explain the 4 price effects created by inflation redistribution of income and wealth?

Answer 1

Inflation

Inflation is just price rise in it's most common meaning and it starts with general rise in level of prices of goods and services daily and weekly.However merely rising prices canot be called be an inflation as it can be for very short time.The rising prices should be sustained and persistent over time,then only it can be called an inflation.It occurs because of two most common reasons:

Demand-Pull Inflation- there occurs a mismatch between demand and supply which gives rise to demand-pull inflation, and

Cost-Push inflation- an increase in cost of factors of production due to wage raise,raw materials becoming costlier would give rise to cost-push inflation.

There are various effects of inflation on an economy both at the micro and macro levels.It redistributes income,unemployment increases,saving and investment policies suffers a great deal and it changes the value of the currency causing an imbalance in trade.During inflation,the purchasing power of income gets reduced.

The redistribution of income and wealth

1) Between salary and wage class- the people earning a fixed income suh as salaried,pensioners and bond holders suffers as the purchasing power is reduced,people often find themselves with less money to spend.There is re-distribution from the fixed income group to the flexible income group.Some wages and salary may increase more rapidly while others will take time same in case of assets.Whereas,Workers belonging to an union may be able to bargain and secure themselves an increaase through various techniques available at their disposal.

2)Lenders and Borrowers - when inflation rises,the interest rates changes accordingly and may show an inflated rate versus it's true rate.There is a redistribution from the creditors to the debtors.

The debtors gain as they secure money at low rates while the creditors will lose as they lend money at low rates than the rate of an inflation.

3)Income and wealth - people hold bonds,stock,real estate and debentures to earn interest and as they earn a fixed rate of interest,they suffer most and they will find their income to be reduced while inflation.Also people's investments in life insurance policies is detoriated.These instruments are often termed as the savings of an individual so the value of savings decline. Also people who already hold assets benefits as the price of their assets such as home or land increase whereas, people who are looking to buy assets may find it difficult and costlier

4)Trade- When the rate of inflation is very high,it decreases the competitiveness of the market as the goods produced in the home country becomes more expensive.Exports suffer whereas imports become cheaper so exports demand will fall and import demand will rise.This will have a negative effect on the country's balance of payments