Outcome of Price Increase - Essay Example

Explain why rising prices do not necessarily mean declining living standards. A trend of rising prices or an increase in the general price level ofan economy is known as inflation. It is also referred to as the sustained increase in the price level. The general perception is that inflation is a bad phenomenon and is detrimental to the growth of an economy. Other than that, there is also a trade-off between inflation and unemployment. If the unemployment rate is low in an economy, this would lead to a higher inflation rate. This is due to the fact that as more people are hired, i.e. an increase in the demand for labour, wages increase and the employers would in turn pass on the cost of higher wages to the consumers resulting in inflation. However inflation cannot always be termed as "bad" if seen in terms of higher money incomes. The higher prices of everything would result in higher receipts for resource suppliers and hence a growth in their income levels. Inflation usually results in the standard of living to decline because it now costs more to buy the same amount of goods and services. However there are some cases where the rising prices do not necessarily mean declining living standards. Following are some of the factors: Nominal Income: If the economy is suffering from a period of rising prices and at the same time there is a commensurate rise in the level of income, this would not lead to a decline in living standards. This is because the increase in prices is offset by the proportionate increase in income, resulting in an unchanged consumption pattern. This is assuming everything else is constant. Real income: This is the income that is adjusted for inflation. In cases where the nominal income is rising but the rate at which it is growing is less than the inflation rate, it would not lead to a boost in the standard of living. This is because the inflation will erode the purchasing power of money and people will be spending the extra income in the purchasing of the same amount of goods and services. However if the growth rate of income is greater than the inflation rate and the net effect is positive, this would mean that the real income is rising. This would enhance the standard of living as now people will be able to afford more of the luxuries and spend more on their entertainment. Since almost all countries are plagued by inflation, people look at their real income to determine their purchasing power rather than the nominal income. Tax structure: In an economy where there is a favourable tax structure, the spending patterns are high. This is due to the fact that even though inflation is prevalent, people still have more of the disposable income left over after their regular purchases. The spending patterns have a multiplier effect and in turn lead a general boom in the economy. The excess spending means people are demanding more goods and services signalling to the producers to produce more. Since the level of production needs to be increased, producers would demand more labour and more production would thus lead to an increase in the national income of the country. To sum it up, tax breaks given to the people will not lead to a decline in the standard of living even in the presence of rising prices. Labour: If the economy has more of the skilled labour as compared to the unskilled workforce and the labour productivity is high, this would also result in a higher standard of living. This is attributed to the fact that since the labour is skilled it would demand higher wages for each extra output it produces. Since the employers would want to retain the skilled labour, it would have to pay higher wages otherwise the labour would find jobs elsewhere. The higher wages would cause more spending and this would maintain or boost the standard of living even though the economy might be in the grips of inflation. Interest rate: The level of interest rates in an economy is an important factor in determining the spending patterns of the consumers. If the interest rate is low, then borrowing is cheap. Consumers would be able to take more loans and buy the things that they previously could not afford. Spending more on consumer durables and luxury items automatically leads to an increase in the standard of living. The society becomes affluent because it is easy to pay the interest on loans as the rate is low and even though the price of each good is higher, people can afford it by taking loans and then paying off those loans at their own terms. Rate of Return on Savings and Investment: People invest their money in financial institutions in order to make a profit and reap the benefits of a high deposit rate at a future date. If the rate of return on savings and investments is less than the inflation rate, then the people do not see a growth in their savings and their money value is eroded. In such a case, the pensioners/ retirees and those people who have a fixed source of income are the worst hit. This is due to the fact that even though they are getting the profit on their savings, it is not enough to counter the losing purchasing power caused by inflation. The extra money that they make goes into buying less of the same goods and services. However in case of real rate of return being positive, that is the rate of return after adjusting for inflation, then the people will see that their incomes are rising, they in turn spending more and hence a higher standard of living. In conclusion, if inflation is within a manageable range or is counteracted by certain favourable economic conditions, it will not lead to a decline in the standard of living. Inflation is real and is present in every economy; the key is to not let it negatively affect the economy. In other words, some of the economic scenarios mentioned above can neutralize the effects on rising prices and in turn, can lead to an even better standard of living if not unchanged. Bibliography: Lipsey, Richard.G & Chrystal, K.Alec, Principle of Economics, 9th Edition. McEachern, William.A, Economics: A Contemporary Introduction, 4th Edition, South Western College Publishing, USA. Mankiw, Gregory. N, Macroeconomics, Worth Publishers, USA. Wiley, John, Economics Theory and Practice, 8th Edition, USA. Sowell, Thomas, Basic Economic, 3rd Edition, Perseus Books Group, USA. McConnell, Campbell & Brue, Stanley, Macroeconomics, 11th Edition, McGraw-Hill. Begg, David, Foundations of Economics, 3rd Edition, McGraw-Hill. http://www.investopedia.com/university/inflation/inflation1.asp Read More