Economics Model Essay - Grade: 1st PDF

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BS1195: Example Essay Question If you were to submit an essay in the following style you would achieve a mark of around 85% - 95%. I am doing this just to show you a high first class standard in order for you to benchmark your work. In reality, very few students will achieve this standard because it’s hard! It is not uncommon for students to score 70-75%, although on average I would expect a mark of around 58%.

What are the economic effects of inflation on a country?

(100%)

Historically, inflation always used to mean an increase in the supply of money. This began to change as the use of precious metals left circulation and countries abandoned the use of the gold and silver exchange standards to take advantage of the perceived benefits of a fiat currency. In modern usage, inflation is usually defined as a continuous rise in the general level of prices. It can be measured in many ways but usually comprises of a basket of goods that are weighted depending consumer consumption patterns. The choice of goods included and the size of the weights is usually determined by a country’s statistical agency; for example in the UK, inflation data is constructed by the Office for National Statistics (ONS). To overcome some of the many pitfalls that arise in calculating inflation, the statistical offices usually offer a number of different classifications. For example, in the UK you commonly hear in the news discussions revolving around the CPI index (used as the Bank of England’s inflation target), the RPI index and the RPIX index which excludes mortgage interest payments. In addition to these, there are also indexes which track various sectors, e.g. wholesale prices, construction prices and house prices.

The prices of goods and services depend chiefly on two factors: (1) the quantity of goods available; and (2) the amount of purchasing power in the hands of consumers. When the volume of purchasing power increases at a faster rate than the output of goods and services, prices will rise. The period of inflation will continue as long as the factors that are causing a continuous tendency for prices to rise operate. It can be said, therefore, that a period of inflation occurs when too much money is chasing too few goods. Indeed as Milton Friedman once famously pronounced: “Inflation is always and everywhere a monetary phenomenon”

(A Monetary History of the United States 1867-1960 (1963))

It is important to remember that inflation can be falling in an economy even though prices are still rising. This is because prices can be increasing at a decreasing rate, e.g. 5% this year compared to 6% last year.

Rising prices stimulate the production of goods and services. A decision to produce is taken in anticipation of demand and if the selling price proves to be higher than expected, then profit margins will be greater than expected. This may then lead to secondary effects via the expenditure multiplier through investors ‘animal spirits’ and rising consumer confidence. Indeed rising prices can be a sign that the economy is near to or even at the full employment level of output.

The incomes of different people take a number of different forms: namely wages or salaries, dividends from profits and fixed incomes. The effects of inflation will impact upon each group differently. The profit effect, discussed above, suggests that those individuals who receive income in the form of dividends tend to gain from bouts of inflation. In contrast wage earners tend to find that price inflation grows faster than their nominal wages so that real wages may actually fall. For this reason they might actually lose during a period of inflation. Finally, people on fixed income, e.g. pensioners, landlords and debenture holders, become progressively worse off as prices rise.

Many economists argue that inflation and in particular uncertain expectations of inflation can have serious deleterious impacts on the effectiveness of the price mechanism to allocate resources. If prices are continually changing do sellers know what level of output to produce? Might consumers delay spending if the rate of inflation is about to fall? Will the market clear ensuring allocative and productive efficiency? These questions are difficult to answer but there is no doubt that volatile and increasing inflation will impact upon all of these factors.

Inflation in the economy can also have serious effects on the country’s balance of payments. Rising prices make domestic goods more expensive in foreign

markets so exports decline. In addition, the extra purchasing power makes imports seem cheaper so a trade deficit will result. This has clear implications for the exchange rate in the medium to long term which in all likelihood would start to depreciate.

Finally, all debtors gain and all creditors lose during a period of rising prices. For example, if a heavily indebted person decides to repay £20 per week for 10 years to an agency that has re-scheduled a large credit card debt, then, if prices and incomes rise, the real value of the £20 will decline. For this very reason home owners benefit from inflation, likewise the government benefits because the national debt is paid off quicker. In contrast, lenders will lose out.

Unchecked inflation can get out of hand. Rising prices cause rising wage demands; if these demands are met, spending power and the costs of production increase, leading to yet higher prices and so another twist of the inflationary spiral. If wage rises are disproportionately large, this process is self-accelerating and a wage-price-spiral might result causing widespread disruption. Because rising and volatile inflation is perceived to have so many negative consequences the Labour Party in 1997 gave the Bank of England independence to control interest rates in order to target inflation at 2% per year. If the bank fails to meet this target (i.e. it undershoots or overshoots by 1%) the Governor of the Bank of England (Mervyn King) has to write a letter to the Chancellor of the Exchequer explaining why. It is thought that by taking away the power to set interest rates from the Chancellor, and thus instituting a monetary policy that favours rules over discretion, will allow inflation and inflationary expectations to be controlled in a credible way. Chancellors would no longer be able to manipulate interest rates for political purposes. Whether the Bank of England has been successful in its goal of targeting inflation via the control of interest rates has recently been bought into doubt. It might be that the UK rate of inflation has been driven by excessive monetary growth elsewhere in the world economy?

Word Count: 1000 words....