Discuss whether inflation is necessarily harmful [12 marks] (27 minutes)

Another potentially harmful effect of inflation can be on the country’s balance of payments. As inflation causes an increase in the prices of domestic goods, these goods become [not sure if I should say relatively here] more expensive for foreigners to purchase leading to a deterioration of the country’s international competitiveness, thus, provided that the exports are price elastic, the quantity demanded for exports is likely to fall, in turn leading to a worsening of the balance of trade and the current account. Moreover, as hot money flows out of the country due to the persistent fall in its value caused by the inflation, the balance of payments position will further deteriorate due to increased debits in the financial account. The likely resulting deterioration of the balance of payments ensuing from this will likely cause a decline in confidence among foreign investors. This fall in confidence due to poor [return on investment risk thingy term that I forgot but will never again forget after I will lose marks for forgetting], would manifest itself through a fall in foreign investments, causing a further deterioration of the balance of payments which would likely cause the exchange rate of the country’s currency, provided it is a floating exchange rate, to depreciate. This would then make imported goods relatively more expensive which may end up leading to a further exacerbation of the issue of inflation through imported inflation in the case where the demand for the imported goods is price inelastic. Thus, through inflation, the economy risks facing a very unfavorable situation as not only can export expenditure fall but import expenditure may also rise following the deterioration of the balance of payments. This would, on the one hand, directly lower aggregate demand by lowering net exports, thus causing a likely fall in economic output, but could, on the other hand, lead to further inflation occurring, thus making all the previous problems even worse.

Despite these possible issues, certain types of inflation can be beneficial to an economy. Under creeping inflation, where the economy experiences a relatively small, stable, rate of inflation of 2-3% annually, the economy can thrive for several reasons. One such beneficial impact would be the increased optimism within various industries. As producers will be able to safely expect prices to continue to rise, they can better justify increased investments or the setting up of new firms, thus allowing for higher output and job creation, leading to an increase in the supply of goods and services, allowing for more to be consumed at a lower price, thus increasing welfare, GDP and allowing for better international competitiveness, in turn leading to a likely improvement in long term growth prospects, a fall in unemployment and a likely improvement of the balance of payments. Moreover, creeping inflation can allow for a lessening of the debt burden on borrowers, thus, once again incentivizing increased investments and spending within the economy by making it easier for people fund startups and expenditure through credit as the loan becomes easier to pay back.

Overall, while certain types of inflation, particularly unpredictable oscillating inflation and hyperinflation can have devastating impacts on the economy by causing a widespread loss of confidence and various other issues including unwanted fiscal drag and wealth redistribution, inflation is by no means necessarily harmful. Provided that the rate of inflation is relatively small and steady at 2-3% it can allow for higher optimism and a lessening of the debt burden leading to stronger incentives for producers to expand, thus promoting an increase in output and helping economic growth.