Impacts of inflation

1. Impacts of inflation

2. Households • Inflation affects the distribution of real income. • People on fixed incomes suffer as the purchasing power of their incomes (their real income) decrease as price levels rise. • People whose incomes rise faster than the rate of inflation experience an increase in their real wage.

3. Households • Inflation tends to result in a more unequal distribution of income as those on lower incomes find their wages do not rise as quickly as those on higher incomes. • In times of high inflation households tend to purchase real assets (e.g. houses, gold, antiques, paintings etc) that retain their real value since their prices rise faster than the inflation rate.

4. Households • As employees nominal wages increase with inflation their real wage (the purchasing power of nominal wages) may remain constant. • Under progressive tax system increased nominal wages may put wage earners into higher tax brackets (higher marginal tax rate). • The percentage on income paid in tax rises even though real wages remain constant. • This is called Bracket Creep or Fiscal Drag.

5. Savers/Borrowers • Inflation encourages current consumption (buy goods and services now before prices rise) and discourages savings. • People with savings suffer in times of inflation as the purchasing power of their savings decreases as price levels rise. • The real rate of interest (nominal rate less the inflation rate) is reduced in times of inflation.

6. Savers/Borrowers • Real interest rates may be negative if inflation rate is greater than the interest rate. If so the purchasing power of savings declines. This discourages savings. • People who have borrowed money benefit as the real value of loans decreases as price levels rise (loans are easier to repay in the future as prices and income rise over time).

7. Savers/Borrowers • Borrowers benefit as inflation reduces the real value (the purchasing power) of the money they owe. • People who have borrowed money benefit as the real value of loans decreases as price levels rise (loans are easier to repay in the future as prices and income rise over time).

8. Firms • Since inflation reduces the incentive for households to save, it causes a shortage of savings for firms to borrow. • Firms finance investment (the purchase of new capital goods) by borrowing money. If there is no savings funds for investment will be limited.

9. Firms • Inflation reduces business confidence and increases uncertainty, which reduces levels of investment. • Reduced levels of investment negatively impact on future production and employment levels. • If rising costs of production caused by inflation (workers demand higher wages to compensate for inflation) cannot be passed on to consumers then firms profits will be reduced.

10. Firms • Costs of production will rise as interests repayments, power, rent, etc become more expensive and workers demand higher wages to compensate for inflation., • If rising costs of production caused by inflation cannot be passed on to consumers then firms profits will be reduced.

11. Trade • If inflation in New Zealand is higher than in our trading partners then NZ goods become less competitive overseas (relatively more expensive). Levels of exports may decline. • Imports into NZ will become relatively cheaper as prices of NZ made goods rise. Demand for local products will fall, decreasing employment levels. • This has a negative impact on NZ’s balance of payemnts.

12. Growth and Employment • High levels of inflation reduce confidence and increase uncertainty (difficult to ptredict the future). • This reduces investment, increases levels of imports, reduces exports, depreciates the value of the local currency, increases unemployment and reduces economic growth. • Increasing prices together with rising unemployment is referred to as “stagflation”.

13. Market efficiency • Inflation distorts the price signals to the market and causes inefficient allocation of resources. • Resources are often allocated to speculative assets (precious metals, shares on the stock market, antiques etc) whose nominal value rises with inflation, but do not add to the levels of output and employment in a country.