Matteo Arellano Mr. Mirza 1.

a) Explain the main consequences of inflation Inflation is defined as a persistent increase in the average price level in the economy, usually measured through the calculation of a consumer price index (CPI). There are many reasons why governments wish to have a low rate of inflation. Inflation normally has negative consequences, which include, by order of importance: loss of purchasing power, negative effect on savings, interest rates and on international competitiveness. It may also lead to uncertainty and labor unrest. There is a loss in purchasing power because if the rate of inflation is 2% for instance, then this means that the average price of all goods and services in the economy has risen by 2% as well. However, in most cases, income remains constant, which means that you will not be able to buy as many goods, and services as you could before due to general increase in the average price level. If income does not receive a cost-of-living increase, then it will reduce purchasing power leading to reduced standards of living. Inflation leads to negative effects on savings. In an account of $1,000 with 4% annual interest, then in one years time it will be $1,040. However, if the interest rate is 6% then the real rate of interestadjusted to inflationwill be negative and the savings will not be able to buy as much as they could have in the previous rate. Therefore, inflation discourages savings leading to higher consumption, probably on fixed assets, such as houses or art. This means that there are fewer savings available for investment, harming the possibilities for economic growth. Commercial banks make their money from charging interest to people who borrow from them. High inflation leads to high nominal interest rates in order to keep the real rate that they earn positive, which, as a consequence creates borrowers must pay higher fees to these banks. High inflation also affects international competitiveness. High inflation makes goods and services less competitive internationally, thus leading to fewer countries importing from a particular country. There will be less export revenues and greater expenditure on imports, thus worsening the trade balance. This may lead to an eventual unemployment in export industries. Finally, inflation may lead to uncertainty, as firms may be discouraged from investing due to the uncertainty associated with inflation. As aforementioned, a fall in the availability of savings may discourage firms to invest. Inflation may create labor unrest if workers feel that their incomes/wages have not experienced a costof-living increase associated to higher inflation rates. b) Evaluate the extent to which demand-side policies are effective in reducing inflation Depending upon the type of inflation, there might be different policies that might be appropriate to reduce it. Demand-pull inflation occurs due to an excess in aggregate demand. Governments may apply deflationary fiscal policieswhich increase taxes and lower government spendingand/or deflationary monetary policieswhich raise

Matteo Arellano Mr. Mirza interest rate and reduce money supply in an economy. These two are also called contractionary demand-side policies. There are positive and negative effects upon applying these policies for reducing inflation. Besides taking into consideration that they are politically unpopular, higher taxes reduces disposable income and lowers the levels of consumption. A reduction in government spending will impact upon different groups of the economy, resulting for less support in the government. In addition, demand-side policies take a long time to have noticeable effects upon the economy. There would be a long time lag involved in using contractionary policy and bringing a decrease in the aggregate demand. Regarding monetary policies, higher interest rates will also harm consumers or investment in the economy and most probably those people who has taken a loan or mortgage. Higher interest rates mean higher loan and mortgage payments, which may lead to temporary higher amounts of consumption of non-durable goods. Nonetheless, monetary policy is considered to be the most effective way of managing aggregate demand in the economy and changes in interest rates are considered the best weapon in the fight against inflation. Fiscal policy is not seen to be as effective as monetary policy to target inflation. The reason for this is that governments are usually committed to their public, and even though they actually applied austerity measures, it would take a long period of time to reduce the price levels. If we are dealing with cost-push inflation, then deflationary demand-side policies may bring down the price level, but they will result in lower national output and are likely to cause unemployment to rise. Thus, demand-side policies for dealing with cost-push inflation are quite ineffective. For monetariststhe other branch of demand-side policiesdealing with inflation is quite plain and simple: stop supplying money into the economy in order to avoid the situation where too much money chases too few goods. This solution is not very effective either as it is very difficult for governments or central banks to control the money supply into the economy. In addition, there would be a possible trade-off between different policy objectives: decrease in AD may lead to an increase in unemployment. Therefore, demand-side policies are to some extent effective at adjusting high levels of inflation as they may create unemployment, or the time lag between the policy and a decrease in the price level might be too long or for instance controlling the money supply in the economy might be too hard and cause trade-off among different macro objectives.