IGCSE Economics 0455 – Government and the Macro‑economy: Inflation – Consequences
Government and the Macro‑economy – Inflation
Objective
To understand the consequences of inflation for consumers, workers, producers/firms and the overall economy.
1. What is Inflation?
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. It is usually measured by the percentage change in a price index such as the Consumer Price Index (CPI).
\$\text{Inflation Rate} = \frac{\text{CPI}{\text{today}} - \text{CPI} {\text{previous period}}}{\text{CPI}_{\text{previous period}}}\times 100\%\$
2. Consequences of Inflation
2.1 For Consumers
Reduced Purchasing Power: As prices rise, the same amount of money buys fewer goods and services.
Cost‑of‑Living Adjustments (COLA): Households may demand higher wages or benefits to keep real incomes stable.
Changes in Spending Behaviour:
Shift from non‑essential to essential goods.
Increased tendency to purchase durable goods early, before further price rises.
Savings Erosion: Real value of money held in cash or low‑interest accounts falls.
Uncertainty: Difficulty in budgeting and planning for the future.
2.2 For Workers
Nominal Wage Increases: Workers often demand higher wages to offset higher living costs.
Real Wage Uncertainty: If nominal wages lag behind inflation, real wages fall, reducing real income.
Negotiation Power: High inflation can strengthen unions’ bargaining position, especially if price‑linked contracts are common.
Employment Effects: Firms may reduce hiring or increase automation to control rising labour costs.
2.3 For Producers / Firms
Higher Input Costs: Prices of raw materials, energy and intermediate goods rise.
Pricing Strategies:
Pass‑through of higher costs to consumers (price increases).
Absorb costs, reducing profit margins.
Uncertainty in Planning: Difficulty forecasting future costs and demand.
Investment Decisions: High inflation may deter long‑term investment due to uncertain real returns.
Menu Costs: Administrative costs of changing prices frequently.
2.4 For the Economy as a Whole
Distortion of Relative Prices: Inflation may affect some sectors more than others, leading to misallocation of resources.
Interest Rate Effects: Central banks may raise nominal interest rates to combat inflation, influencing borrowing and investment.
Balance of Payments: Higher domestic prices can reduce export competitiveness and increase import demand, widening the trade deficit.
Fiscal Impact: Inflation can increase tax revenues (bracket creep) but also raise public spending on indexed benefits.
Inflation Expectations: If agents expect inflation to continue, it can become self‑reinforcing (inflationary spiral).
3. Summary Table of Consequences
Group Affected
Positive Consequences
Negative Consequences
Consumers
Potential for earlier purchase of durable goods before prices rise.
Reduced real income, savings erosion, uncertainty.
Workers
Opportunity for nominal wage increases.
Real wages may fall if wage growth lags; job insecurity.
Producers/Firms
Possibility to increase selling prices and improve revenue.
Higher input costs, reduced profit margins, planning uncertainty, menu costs.
Economy
Short‑term boost to nominal GDP if output rises with price level.
Distorted relative prices, reduced competitiveness, higher interest rates, inflation expectations.
Suggested diagram: The “inflation‑impact” flow chart showing links between price level, consumer purchasing power, wage demands, firm costs, and macro‑economic variables (interest rates, trade balance, inflation expectations).
4. Key Points to Remember
Inflation reduces the real value of money, affecting everyone in the economy.
Consumers feel the impact immediately through higher prices; workers experience it through wage negotiations.
Firms must decide whether to pass on higher costs or absorb them, influencing profitability and investment.
At the macro level, persistent inflation can lead to higher interest rates, reduced export competitiveness and altered fiscal balances.
Expectations matter – if people expect inflation to continue, it can become self‑fulfilling.