ECONOMICS PAST PAPER QUESTIONS WITH ANSWERS - price elasticity and inflation.

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ECONOMICS PAST PAPER QUESTIONS WITH ANSWERS.

Q1) Discuss whether inflation is necessarily harmful. (12)

ANS 1:-   Inflation is usually defined as a situation in which there is a persistent increase in the general price level.  During inflation, cost of living rises, and hence, the purchasing power or the value of money falls. Usually inflation is an evil to an economy, and hence, reducing inflation is one of the macro-economic aims of every government. However, the effects of inflation depend on its level, whether it is constant or accelerating and whether it is anticipated or unanticipated. There are lots of economic costs associated with inflation:-

  1.  Shoe-leather costs:  High rates of inflation mean that people and companies may lose considerable purchasing power if they keep money lying idle and not earning interest. Inflation erodes the value of cash and therefore, firms and households prefer to hold less cash but more interest bearing deposits / assets. Shoe leather costs are the costs involved in moving money from one financial asset to another in search of the highest rate of interest.
  2. Menus costs:  Firms will also suffer from menu costs. These are the costs involved in changing prices. For examples, firms have to incur costs by changing price labels or prices in catalogues (new price lists) or on menus or to adjust slot machines.
  3. Redistribution:  Inflation leads to an arbitrary redistribution of real income. Different income groups will be affected in different ways. In other words, there will be some “gainers” and some “losers”. A fall in the value of money will remove purchasing power from those living on fixed incomes, such as pensioners, and redistribute it towards those who draw their living from prices. Similarly, workers with weak bargaining power who cannot gain full compensation for price rises will lose at the expense of workers with strong bargaining power who can do so. Furthermore, if inflation is not fully anticipated, that is, if real interest rate is negative, there will be a redistribution of income from lenders to borrowers. In fact, lenders will lose and borrowers will gain. The spending power of lenders will be eroded by inflation since when the money is paid back, less goods will be purchased.
  4. Uncertainty and lack of investment: Inflation creates unemployment and lowers growth. Inflation increases costs of production and creates uncertainty in the business community. If it is difficult for firms to predict their costs and revenues, they may be discouraged from undertaking the risk associated with any investment project.
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However a low rate of inflation around the 2-3% may be desirable. The beneficial effects of inflation are :-

  1. Inflation may encourage firms to expand. A low and stable level of demand-pull inflation may make entrepreneurs optimistic about future sales.
  2. It can prevent some workers being made redundant. This is because it may be difficult to cut nominal wages (workers resent wage cut). But, if average prices are rising they may accept their money wages rising by less than inflation. In such a case, firms’ real wage costs will fall without making workers redundant.

Q2) ...

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