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Costs of inflation and deflation and evaluation of supply side policies
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a) explain the costs of Inflation and the costs of deflation
b) Evaluate demand side policies as a means of reducing Inflation.
Inflation is a consistent increase in the general price level. It has many causes and costs. The reason that governments wish to have a low rate of inflation is because inflation leads to a lot of negative consequences and costs which affect the economy harmfully.
The increase in aggregate demand causes excess demand and prices are raised from r0 to r1
During inflation, prices changes arbitrarily which means that some prices rise easily while others do not. This distorts the price system. Wrong signals are sent to markets, and resources no longer move according to relative values and scarcities. Resources are redistributed randomly and there are some gainers and losers.
People on relatively fixed incomes will suffer a fall in real income e.g. those receiving age pensions. However, those with power to increase their incomes will gain during inflation. Moreover, Borrowers will gain at the expense of lenders.
Uncertainty is also a cost of inflation. Because as inflation occurs the market forces keeps changing which doesn't
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