Question

Describe the goal of price stability and the costs associated with inflation (i.e., why is inflation harmful to society).

Answer 1

The goal of price stability is to keep the general price level stable, to avoid prolonged periods of inflation or deflation

Costs of inflation

1. Reduced international competitiveness: Inflation reduced the competitiveness of the domestic products as these would be more expensive in the international market leading to a decline in exports. This is especially so in case of fixed exchange rates.
2. Fall in investment by firms. Inflation leads to a decline in investment by firm because there is uncertainty. Firms will reduce the amount of investments till the economic situation becomes more stable. Aggregate demand falls.
3. High inflation is followed by recession, leading to economic downturn.
4. Decline in real income. Inflation leads to a decline in real income. This will impact the elderly, retired and income from savings will be reduced. Real wages will fall.
5. Bondholders will lose out as the returns on bonds will be lower because of the inflation. Bond prices will fall because of inflation.
6. Menu costs as firms will have to frequently change prices.
7. Shoe-leather costs as individuals will hold less cash and make frequent trips to the bank to withdraw money.