Question

1. What are the four problems associated with inflation?

Ans:

2. What is the Fisher effect? Provide the formula with the breakdown.

Answer 1

PROBLEMS WITH INFLATION

1) ERODES PURCHASING POWER - INFLATION IS A DECREASE IN THE PURCHASING POWER OF CURRENCY DUE TO A RISE IN PRICES ACROSS THE ECONOMY. INFLATION REQUIRES PRICES TO RISE ACROSS A BASKET OF GOODS OF SERVICES SUCH AS THE ONE THAT COMPRISES THE MOST COMMON MEASURE OF PRICE CHANGES , THE CONSUMER PRICE INDEX (CPI) .

2) REDUCES EMPLOYMENT AND GROWTH

3) WEAKENS THE CURRENCY - HIGH INFLATION IS USUALLY ASSOCIATED WITH A SLUMPING EXCHANGE RATE , THOUGH THIS IS GENERALLY A CASE OF THE WEAKER CURRENCY LEADING TO INFLATION , NOT THE OTHER WAY AROUND..

4) FALLING REAL INCOMES - RISING INFLATION LEADS TO A FALL IN REAL INCOMES...

5) COST OF BORROWING - HIGH INFLATION MAY ALSO LEAD TO A HIGHER BORROWING COSTS FOR BUSINESSES AND PEOPLE NEEDING LOANS AND MORTGAGES AS FINANCIAL MARKETS PROTECT THEMSELVES AGAINST RISING PRICES AND INCREASE THE COST OF BORROWING ON SHORT AND LONGER TERM DEBT....

FISHER EFFECT - THE FISHER EFFECT IS AN ECONOMIC THEORY CREATED BY ECONOMIST IRVING FISHER THAT DESCRIBES THE RELATIONSHIP BETWEEN INFLATION AND BOTH REAL AND NOMINAL INTEREST RATES...THE FISHER EFFECT STATES THAT REAL INTEREST RATE EQUALS THE NOMINAL INTEREST RATE MINUS THE EXPECTED INFLATION RATE...THEREFORE , REAL INTEREST RATES FALL AS INFLATION INCREASES , UNLESS NOMINAL RATES INCREASE AT THE SAME RATE AS INFLATION....