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A)Why Should Every Government Be Concern With Inflationary Pressure?

Essay by   •  May 5, 2011  •  610 Words (3 Pages)  •  1,766 Views

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Inflation is defined as a sustained, inordinate and general increase in prices. The Consumer Price Index is used to measure changes in the general price level from base year to current year. The internal value of money is determined by its purchasing power. An increase in the general price level implies a fall in the internal value of money and the occurrence of inflation. There are three degrees of inflation- creeping inflation whereby inflation proceeds for a long time at a moderate and fairly steady pace; galloping inflation whereby inflation proceeds at a very high rate and stagflation whereby the level of national income and output remain stagnant while the general price level increases.

Every government should be concerned with inflationary pressure because of the internal and external effects of inflation. At the micro level, inflation will bring about redistributive and output/production effects. For the fixed income earners such as pensioners, wage earners and salaried workers, when price level rises, the real value of their income is eroded by inflation. As a result, they can only purchase fewer goods and services than before. Also, the persistent increase in prices will lead to an increase in the cost of living. Assuming ceteris paribus, living standards will be lowered since luxuries have to be given up to pay for the basic necessities.

When prices change rapidly and in an unpredictable manner, both consumers and producers will find it difficult to calculate relative prices necessary for their rational decision making process. The different rates of changes in prices will result in changes in relative prices and this may lead to inappropriate production and consumption decisions, hence a misallocation of resources. For example, inflation may cause some business firms to mark up their prices by more than what is necessary to compensate for the increased risks they perceive. The price distortions would cause a reduced quantity of goods and services to be demanded and thus distortions in the amount produced.

There will be external effects when inflation occurs for an open economy. Such effects will be of greater significance for a country that is highly dependent on international trade. An increase in prices domestically will discourage

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