EMBA 1ST SEMESTER

BUSINESS ECONOMICS - ECO400

ASSIGNMENT#02

SUBMITTED TO: Ms. SAIRA HABIB

SUBMITTED BY: MUHAMMAD USMAN
REG. NO: SP15-EMBA-290
EMAIL : sp15emba290@vcomsats.edu.pk
DATED: 8 May, 2014

Q.1
Inflation
It can be defined as a sustained increase in the average price level of a country or in simpler
words we can say that Inflation means that our money wont buy as much today as we could
yesterday. For example, if the price of oil goes from $75 a barrel to $100 a barrel, input prices
for businesses increase and transportation costs for everyone increase and this may cause many
other prices to raise in response. However, most economists describe a different impact when
they talk about inflation. Inflation is a function of the supply and demand for money, meaning
that producing relatively more money causes each monetary unit to become less valuable,
making the general price level rise.
The rate of inflation is measured by the annual percentage change in the level of prices as
measured by the consumer price index (CPI). The theory of free markets describes the
importance of the price mechanism for determining prices in any economy. If there is any
shortage, sellers raise their prices, and whenever there are surpluses, prices would fall. The price
mechanism is important for relative prices but with inflation we are concerned with overall
changes in the rate of inflation,

Is inflation good or bad for economy?

A small amount of inflation can be viewed as having a beneficial effect on the economy.
However, if uncontrolled, it can prove to be a disaster for any economy. In the coming
paragraphs, both the favorable and adverse impacts of inflation on the economy are discussed;

Benefits of controlled or moderate inflation

Deflation (a fall in prices also known as negative inflation) is very
harmful
During a prolonged period of deflation or very low inflation, the economy suffers lower
growth because of deflationary pressures. When prices are falling, people are reluctant to
spend money because they are concerned that prices will be cheaper in the future, therefore,
they keep delaying purchases. Also, deflation increases the real value of debt and reduces the
disposable income of individuals who are struggling to pay off their debt. When people take
on a debt like a mortgage, they generally expect an inflation rate of 2% to help erode the
value of debt over time. If this inflation rate of 2% fails to materialize, their debt burden will
be greater than expected.
Moderate inflation enables adjustment of wages
It is stated that a moderate rate of inflation makes it easier to adjust relative wages. For
example, it may be difficult to cut nominal wages (workers resent and resist nominal wage
cut). But, if average wages are rising due to moderate inflation, it is easier to increase the

wages of productive workers wages; unproductive workers can have their wages frozen,
which is effectively a real wage cut. If we had zero inflation, we could end up with more real
wage unemployment, with firms unable to cut wages to attract workers.
Inflation enables adjustment of relative prices
Moderate inflation makes it easier to adjust relative prices. It is particularly important for a
single currency like the Eurozone. Southern European countries like Italy, Spain and Greece
became uncompetitive, leading to large current account deficit. Because Spain and Greece
cannot devalue in the Single Currency, they have to cut relative prices to regain
competitiveness. With very low inflation in Europe, this means they have to cut prices and
cut wages which causes lower growth (due to effects of deflation). If the Eurozone had
moderate inflation, it would be easier for southern Europe to adjust and regain competitive
edge without resort to deflation.
Inflation can boost growth
With very low inflation rate, the economy may be stuck in a recession. Arguably targeting a
higher rate of inflation can enable a boost in economic growth. However not all economists
would support targeting a higher inflation rate because some would target higher inflation, if
the economy was stuck in a prolonged recession.

Adverse impacts of inflation on the economy

INFLATION CREATES UNCERTAINTY AND CONFUSION

When inflation is high, it also tends to be more volatile. It becomes more difficult for firms to
predict future prices and costs, therefore they tend to reduce or delay investment decisions.
Therefore this tends to adversely affect economic growth in the long term. The growth of
ones economy may be burdened by inflation. However, if policymakers are looking into
things seriously, every nation can hurdle the setbacks of inflation by implementing measures
to overcome the negative effects of inflation.
LOWER COMPETITIVENESS

High inflation creates less competitiveness compared to other possibly balance of payments
problems. This is increasingly important with the globalization of the world economy. If we
do lose competitiveness in the long term it is likely to lead to devaluation in exchange rate.
INFLATIONARY GROWTH IS UNSUSTAINABLE

Economic growth above the long run trend rate also caused inflation leading to a boom and
bust economic cycle. Keeping inflation close to the governments target is one of the best
ways of avoiding inflationary growth and maintaining sustainable economic growth.
INFLATION REDUCES THE VALUE OF SAVINGS

This is because inflation erodes the value of money. This is likely to affect pensioners the
most. Therefore, inflation is thought to cause a redistribution of income within society from

savers to borrowers. However, this is only a problem if inflation is higher than the rate of
interest. If interest rates are above the value of inflation then savers can still maintain the
value of their savings. The impact of inflation to an ordinary family gives us a clear
indication that the value of our money is no longer the same as yesterday. Wise spending is
basic rule for a debt free life. The basic needs should be prioritized instead of buying things
that are of less importance.