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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]


Macroeconomic Factors and Policies

CIE AS level November 2021

Preview 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.

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