Essay, Macro: Inflation
a. Explain why low inflation is a macroeconomic objective of a government. (10) b. Discuss whether globalisation will always help to lower the inflation rate of a country. (15)
def Inflation refers to a persistent increase in the general price level of goods and services in an economy over a period of time, usually measured over a year. Governments usually wish to achieve low and stable inflation, as it increases business confidence, encourages savings, and minimises costs such as menu costs.
business certainty High and unpredictable interest rates are regarded as harmful as they make it difficult for businesses to make long term plans for investments, as they are unsure over the future purchasing power of money. For example, although Vietnam's economy was growing rapidly in the 2000's, high demand pull inflation made many MNCs reluctant to invest more in the country. A low and stable inflation rate allows businesses to make confident forecasts and increase certainty in their production and sales decisions.
encourage savings Low inflation rates also encourage savings. In a country with high inflation rates, households would experience a rapid decline in the real value of savings since inflation depresses the real rate of interest. This incentivises households to spend now instead of saving for the future. In the long run, the level of investments in the country depends on the amount of savings available, and a low savings rate would lead to low investment and slower economic growht.
menu costs Finally, high interest rates imposes costs on businesses, who have to change their prices to keep up with inflation. Frequent changes of prices impose both an explicit cost of printing new menus and implicit costs that come with the extra time and effort needed to adjust prices constantly.
In conclusion, most governments have an incentive to keep inflation low to avoid the problems above. However, governments may sometimes have an incentive to keep inflation high. For instance, inflation would erode the real value of debt, which would make government debt more easy to pay off. Too low an inflation rate might also signal weak demand in the economy, and governments have to be careful in managing the economy to be aware of its other economic goals, such as economic growth.
b) Discuss whether globalisation will always help to lower the inflation rate of a country. (15)
def Globalisation is defined as a process of deeper economic integration between countries involving an expansion of trade in goods and services, transfers in financial capital between countries, and more free movement of labour.
Globalisation can lead to lower prices due to economies of scale and the ability of firms to access cheaper inputs from the global market. At the same time, it might also lead to higher prices as globalisation drives demand and leads to increased competition for resources.
goods and services The free movement of goods and services between nations and the falling costs of international transport has led to increased trade. As countries specialise in goods in which they have a comparative advantage, the prices of internationally traded goods fall. Also, with a global market, firms can reap larger economies of scale and lower their costs. Finally, the elimination of tariffs and quotas due to the forces globalisation further allows consumers to buy goods and services at lower prices.
labour Globalisation has also allowed labour to move more freely to where demand is highest. Labour supply hence shifts to the right and becomes more price elastic. This leads to a shift in the AS curve to the right.
capital Finally, globalisaton has led to a standardisation of international financial regulations, allowing freer flow of FDI. The inflow of FDI brings with it capital and technology, which increases productivity, reduces costs and expands output in the long run.
However, globalisation might also lead to higher inflation rates.
goods and services As nations join the global economy, they will experience in demand in their export facing industries. This would lead to higher aggregate demand and drive demand-pull inflation, especially if the country is already near full capacity. For example, there have been concerns that China's manufacturing industry has been overheating, which has led to inflationary pressures in the country.
Globalisation also leads to an increase in the demand for commodities and energy, leading to higher prices, which drives up the costs of production. This leads to imported inflation in countries which are reliant on imports for raw materials and neccessities, such as Singapore.
labour The free flow of labour also leads to the phenomenon of brain drain. For instance, Spanish engineers might not be able to find suitable jobs due to the current Euro crisis, and can migrate very easily to Germany. While Germany benefits from an increase in engineer supply, the supply in Spain dries up, pushing labour costs for the remaining engineering firms. This causes the AS to shift left.
capital Finally, increase in FDI will lead to a higher demand for labour and raw materials, which leads to demand pull inflation.
conclusion Although globalisation is likely to lead to lower prices in the long run, it may also lead to increased demand and inflationary pressure. Whether globalisation would ease or worsen inflation would depend on its openness to trade, the size of its economy, the availability of capacity to soak up export demand, and government policies to manage inflation.
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