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Domestic vs. External Effects of Inflation

Discuss whether the domestic effects of inflation are more serious than the external effects for an economy.

[12 marks]

Category:

Macroeconomic Factors and Policies

CIE AS level November 2021

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Answer



(Step 1: Define inflation)


Inflation is the name given to an increase in price levels generally. It is also manifest in the decline in the purchasing power of money. Inflation does not mean that the price of every good and service increases, but that on average the prices are rising. The effects of inflation for the economy can be both domestic and external.


(Step 2: Discuss the domestic effects of inflation)



Inflation can have far reaching effects on domestic output business profits and employment.

(1) 🪙Inflation reduces the value of money.

Governments aim to control inflation because it reduces the value of money and the spending power of households, governments and firms.


(2)🪙 An unplanned redistribution of income.

People on fixed incomes (such as students or pensioners) may find themselves worse off, as
their income will not rise even though the cost of goods has increased.

If the rate of interest does not rise in line with inflation, borrowers will gain and lenders (savers)
will lose. This is because borrowers will pay back less in real terms and lenders will receive less.


(3) 🪙Shoe leather costs.

Inflation causes fluctuations in price levels, so customers spend more time searching for the
best deals. This is known as shoe leather costs.


(4) 🪙Inflation causes uncertainty among the business community.

If it is difficult for firms to predict their costs and revenues. Inflation also requires firms to use extra resources to cope with its effects. Catalogues, price lists and menus have to be updated regularly and this is costly to businesses. Of course, workers also have to be paid for the time they take to reprice goods and services. This is known as menu costs.

The costs of inflation may ’be relatively mild if inflation is kept to single figures. They can be very serious, however If inflation develops into ’'hyperinflation” with prices rising perhaps by several hundred per cent or even thousands per cent per year, the whole basis of free market economy will be undermined.


(5) 🪙 Inflationary spiral.

Inflation may generate further inflation as consumers, workers and firms will come to expect prices to rise. As a result, they may act in a way that will cause inflation. For example, workers may press for higher wages, firms may raise prices to cover expected higher costs and consumers may seek to purchase products now before their prices rise further. Thus prices and wages chase each other in an ever-rising inflationary spiral.




(Step 3: Discuss the external effects of inflation)



Inflation also have external effects for an economy.

(1) 🪙The balance of trade will be affected

If a country has a higher rate of inflation than its major trading partners, its exports will become
relatively expensive and imports relatively cheap. As a result, the balance of trade will suffer,
affecting employment in exporting industries and in industries producing import-substitutes.
Eventually, the exchange rate will be affected.


(2) 🪙International competitiveness is reduced.

When the price level in a country increases more rapidly than the price level in other countries with which it trades, its exports become more expensive to foreign buyers, while imports become cheaper to domestic buyers. The country's international competitiveness, or its ability to compete with foreign countries, is reduced.


(3) 🪙The terms of trade will be impacted.

In the short term, the effect on export and import demand tends to be low because of low price elasticity of demand. There­fore, an improvement in its term of trade caused by rising export prices could improve country’s export earnings and hence trade balance. In the long run, however, a relatively higher rate of inflation makes a country’s exports less price competitive in the world markets.






(Step 4: Conclude whether the domestic effects of inflation are more serious than the external effects for an economy. )





Domestic effects of inflation are wide spread, therefore, government should be concerned with the domestic effects rather than it's external effects. It is possible for a country to have a relatively high rate of inflation but if it is below that of rival trading partners, its products may become more internationally competitive. However, if a country is highly dependent on foreign trade , a government should be more concerned with the external effects of inflation, specially if the inflation rate is higher than that of rival countries. This is because domestic stability is directly linked with the country’s trade performance. If one country has a much higher rate of inflation than others for a considerable period of time, this will make its exports less price competitive in world markets. Eventually this may show through in reduced export orders, lower profits and fewer jobs, and also in a worsening of a country’s trade balance. A fall in exports can trigger negative multiplier and accelerator effects on national income and employment.






> EXAMINER'S REPORT<


Again, there were some very good answers, and most candidates were able to clearly and accurately distinguish between domestic and external effects. There were also some good attempts to evaluate their relative seriousness often in different scenarios, most commonly the degree of openness of the economies. Weaker answers either failed to distinguish effectively between domestic and external effects and/or simply asserted effects without explanation. For example, fiscal drag may well be an effect but without explanation it is simply knowledge and gains no credit. Some candidates also attempted to evaluate the general effects of inflation and/or the policies used to deal with inflation which of course was not the question and therefore could not be credited.


> MARKING SCHEME <

For analysis of the domestic effects of inflation
For analysis of the external effects of inflation
8 marks maximum

For evaluative comment that assesses the relative seriousness of the internal and external effects ( up to 3 marks)

And leads to a reasoned conclusion as to which effect is likely to be the most serious for an economy (1 mark)


The domestic effects include a haphazard
redistribution of income, a fall in savings
and productive investment, menu and shoe
leather costs
The external effects include a rise in the
price of exports and a fall in the relative
price of imports with implications for the
current account of the balance of payments,
the exchange rate and capital flows
If any part of the answer confuses domestic
effects with external effects, then this part
should not be rewarded. However, parts
that are accurate should be rewarded
Note: there are no KU marks awarded in
part (b) for merely explaining/defining terms
or phrases used within the question

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