Free AIOU Solved Assignment Code 808 Spring 2021
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Course: Public Finance and Fiscal Policy (808)
Semester: Spring, 2021
ASSIGNMENT No. 1
Q.1 Discuss in detail the concept of social good and market failure.
Market failure is the economic situation defined by an inefficient distribution of goods and services in the free market. Furthermore, the individual incentives for rational behavior do not lead to rational outcomes for the group. Put another way, each individual makes the correct decision for him/herself, but those prove to be the wrong decisions for the group. In traditional microeconomics, this is shown as a steady state disequilibrium in which the quantity supplied does not equal the quantity demanded.
Positive externalities are benefits that are infeasible to charge to provide; negative externalities are costs that are infeasible to charge to not provide. Ordinarily, as Adam Smith explained, selfishness leads markets to produce whatever people want; to get rich, you have to sell what the public is eager to buy. Externalities undermine the social benefits of individual selfishness. If selfish consumers do not have to pay producers for benefits, they will not pay; and if selfish producers are not paid, they will not produce. A valuable product fails to appear. The problem, as David Friedman aptly explains, “is not that one person pays for what someone else gets but that nobody pays and nobody gets, even though the good is worth more than it would cost to produce.
Most economic arguments for government intervention are based on the idea that the marketplace cannot provide public goods or handle externalities. Public health and welfare programs, education, roads, research and development, national and domestic security, and a clean environment all have been labeled public goods.
Externalities occur when one person’s actions affect another person’s well-being and the relevant costs and benefits are not reflected in market prices. A positive externality arises when my neighbors benefit from my cleaning up my yard. If I cannot charge them for these benefits, I will not clean the yard as often as they would like. (Note that the free-rider problem and positive externalities are two sides of the same coin.) A negative externality arises when one person’s actions harm another.
- Market failure occurs when individuals acting in rational self-interest produce a less than optimal or economically inefficient outcome.
- Market failure can occur in explicit markets where goods and services are bought and sold outright, which we think of as typical markets.
- Market failure can also occur in implicit markets as favors and special treatment are exchanged, such as elections or the legislative process.
- Market failures can be solved using private market solutions, government-imposed solutions, or voluntary collective actions.
A market failure occurs whenever the individuals in a group end up worse off than if they had not acted in perfectly rational self-interest. Such a group either incurs too many costs or receives too few benefits. The economic outcomes under market failure deviate from what economists usually consider optimal and are usually not economically efficient. Even though the concept seems simple, it can be misleading and easy to misidentify.
Contrary to what the name implies, market failure does not describe inherent imperfections in the market economy—there can be market failures in government activity, too. One noteworthy example is rent-seeking by special interest groups. Special interest groups can gain a large benefit by lobbying for small costs on everyone else, such as through a tariff. When each small group imposes its costs, the whole group is worse off than if no lobbying had taken place.
Additionally, not every bad outcome from market activity counts as a market failure. Nor does a market failure imply that private market actors cannot solve the problem. On the flip side, not all market failures have a potential solution, even with prudent regulation or extra public awareness.
Commonly cited market failures include externalities, monopoly, information asymmetries, and factor immobility. One easy-to-illustrate market failure is the public goods problem. Public goods are goods or services which, if produced, the producer cannot limit its consumption to paying customers and for which the consumption by one individual does not limit consumption by others.
Public goods create market failures if some consumers decide not to pay but use the good anyway. National defense is one such public good because each citizen receives similar benefits regardless of how much they pay. It is very difficult to privately produce the optimal amount of national defense. Since governments cannot use a competitive price system to determine the correct level of national defense, they also face major difficulty producing the optimal amount. This may be an example of a market failure with no pure solution.
There are many potential solutions for market failures. These can take the form of private market solutions, government-imposed solutions, or voluntary collective action solutions.
Asymmetrical information is often solved by intermediaries or ratings agencies such as Moody’s and Standard & Poor’s to inform about securities risk. Underwriters Laboratories LLC performs the same task for electronics. Negative externalities, such as pollution, are solved with tort lawsuits that increase opportunity costs for the polluter. Tech companies that receive positive externalities from tech-educated graduates can subsidize computer education through scholarships.
Governments can enact legislation as a response to market failure. For example, if businesses hire too few teenagers or low skilled workers after a minimum wage increase, the government can create exceptions for younger or less-skilled workers. Radio broadcasts elegantly solved the non-excludable problem by packaging periodic paid advertisements with the free broadcast.
Governments can also impose taxes and subsidies as possible solutions. Subsidies can help encourage behavior that can result in positive externalities. Meanwhile, taxation can help cut down negative behavior. For example, placing a tax on tobacco can increase the cost of consumption, therefore making it more expensive for people to smoke.
Private collective action is often employed as a solution to market failure. Parties can privately agree to limit consumption and enforce rules among themselves to overcome the market failure of the tragedy of the commons. Consumers and producers can band together to form co-ops to provide services that might otherwise be underprovided in a pure market, such as a utility co-op for electric service to rural homes or a co-operatively held refrigerated storage facility for a group of dairy farmers to chill their milk at an efficient scale.
AIOU Solved Assignment Code 808 Spring 2021
Q.2 Explain in detail the process of Budget preparation and its approval in Pakistan.
The aim of any government is to fulfill the socioeconomic responsibilities in order to break the vicious cycle of poverty and also uplift the economic conditions. In Pakistan it has been practiced that the aggregate of tax collection and no tax collection revenues are not ample to meet the government expenditure. To fulfill the gap between the spending and revenues so the economist used the perception of deficit financing. The government borrowing from banking and non-banking sector and printing new currency is called deficit financing. Deficit financing shows the difference between projected expenditure and projected spending. To fill the gap of government borrows from 1) state bank of the country 2) borrow from commercial banks 3) borrows from non-financial sector such as saving centers, insurance companies 4) the last source is printing new notes known as deficit financing. Deficit financing is a situation where government spends more money than its revenue collection. Deficit financing is used for different purposes the main purpose of deficit financing is used to end the recession when the economic activity slowdown in order to retrieve the economy in the better situation. In the third world countries like Pakistan the deficit financing becomes the requirement due to bad governance, insufficient spending policies, corruption, tax evasion, and insufficient tax collection.
In the west the phrase Deficit Financing is used to explain the intentionally create a difference between public revenues and expenditures or the budget deficit. This gap or difference can be filled by public borrowing, commercial banks, and central bank. The idle saving of is used to fill this gap that in turn increase the employment and output of the country.
Deficit financing is the most important tool of generating capital in developing and underdeveloped countries. In developed nation the new currency notes are used to support the public investment that in turn increases the growth rate of a country. The government used the borrowed money for the development purposes i.e. railways, roads, air services, social overhead capital, schools, hospitals etc. The deficit financing is also used to increase the economic activity of a private sector in the country.
The monetary expansion in developing countries attached with high rate of borrowing from banks and international sources to finance their budget deficit, budget deficit is the one factor that contributes in disequilibrium in the balances of payments. In developing countries governments are unable to mobilize or use their domestic resources due to inefficient tax system, in such countries the capital market are also underdeveloped and the interest rate determines institutionally. In such circumstances the supply of money increase that causes an increase in the price level. There are different sources of financing the economic development; these resources are domestic resources and foreign resources. Domestic resources are those in which the government finances through taxation, public borrowing, and the saving of government that include the surplus and also include the deficit financing. The foreign source of finance consists of loans, grants, and private investment. The significance of both domestic and foreign resources has their own in developing countries. The most important thing is used to execute these resources in a way that maximum benefit can be achieved for rapid development. Pakistan is a large country with a population of 17.50 million in 2010. The economy of Pakistan is still facing the low level of per capita income that is stranded at 699 US $ in December 2012. In Pakistan the ratio of the budget deficit is different in different years. From last two decades the budget deficit is 5.4% to 8.7% of GDP. The average deficit rate was 6% in the period of 1970and it was 7.6% in the period of 1980.In 1990s the deficit ratio was decreased to 6.4% of GDP due to a reduction in development expenditure. The ratio was not achieved by enhancing the tax system but due to the reduction in the development expenditure. The Pakistan tax system is still narrow and punctured due to the poor and weak tax administration.
The balance of payments deficit has become a permanent problem of Pakistan’s economy. For the last fifty years Pakistan has been facing continuously from a current account deficit. The international loans are used to finance the deficit. The debt service charged more than 5% of the GDP of the country. With large budget deficit there is need of rapid growth of domestic credit. In underdeveloped countries the role of free capital markets is limited. The main source of government deficit is financed by the banking system. Like other developing countries Pakistan is also facing a large budget deficit as the most outstanding problem. Deficit financing is also responsible for high inflation rate, decrease growth rate, and low opportunities for private investment. Pakistan faces different rates of the budget deficit in different years. In last two decade the budget deficit ratio was 5.4% -8.7% of GDP. The ratio was 7.6% in 1980’s the ratio became 7.6% in 2001- 2002. The rate of budget deficit in Pakistan has grown consistently with the passage of time. At the time of 80’sthe budget deficit has increased as much as faster than the early periods and touched the ratio of 8.4% in 1987-88. The rate of budget deficits has decreased to 7% but that ratio was also considered high one of the experts. Due to large budget deficit there was a high rate borrowing is used to responsible for an increase in the domestic debts since 1980-81. In the period of 90’s the severe situation faced by the State Bank of Pakistan to control inflation within the targeted limit and make sure the macroeconomic stability. In the fiscal year of 1998 and 2003 the rate of inflation was 4.6% that were relatively lesser the best rate. In early 1973 and 1980 the inflation rate was two digit figures that were 14.3%. The rate of inflation controlled in the period of 1980 that was 7.2% per annum but unfortunately the rate of inflation again grown to 10% per annum. The high rate of inflation also caused due to excess money supply, fiscal imbalances, and deficit finance sources. Chaudary and Hamid (2001)Pakistan are facing severe obstacles of generating public revenue. The persistent failure in attainment of public revenue leads the public sector to depend on public borrowing. The result is that the public debt goes to increase the rate of 90% of GDP and the rate of budget deficit increase to 8% of GDP. The figure of budget deficit lead to double digit inflation (ref). These imbalances adversely affect the economy. These problems all are interconnected with each other in order to decrease the public revenues that in turn create the hindrance to meet the needs of the public expenditures. In this regard the efforts are made to improve the taxation system that is not based on the scientific approach, that’s why the to attain the target of achieving the projected target failed continuously. The result is that it is not only used to meet the demands of development projects because at that time it not able to meet the demand of the current expenditure. In Pakistan the less than 1% population is taxpayer. According to the economic survey of (1998-99) Pakistan has experienced the sustainable growth rate more than three decades till 1990. Pakistan’s economy grew at the rate of 6% per annum more than three decades but the situation became adverse in 1990. The collection of tax also became very adverse at a satisfactory level.
The other developing nations like Pakistan at the age of early growth need to get higher revenue than the developed nations. Due to the obstacles that prevail in getting the higher growth rate this could lead to the unsustanability to survive. According to the economic survey of 1998-99 the growth rate of Pakistan goes to down at 4.5% per annum, the ratio was about 6% in the last 3 decades and same ratio was 3% for few years. The deficit finance is the result of failure in an increase in the public sector to increase their savings. The trend shows that the efforts made in collecting taxes do not meet the demand of the public. It is important to note that Pakistan is not attaining the targeting revenue through tax. According to world development report (1979, 1991and 1997) the rate of tax collecting in the other developing countries is 25%. In the period of 1998-99 the tax shortfall was approximately 20%; it shows that there is need of detailed study of the tax reform system. The economic crises over in 2008, Pakistan have enjoyed greater economic activity. The policy maker in Pakistan’s fights a battle against the crisis hit in 2008-2009. The sudden increase in the oil prices also causes the alarming situation for the deficit in foreign debt and also decrease the value of the rupee. Pakistan made efforts to seek the international monetary fund after the allies of China, USA, and Saudi Arabia to refuse to provide the funds to the country in October 2008. Pakistan has provided the US$ 1 billion loan for 23 months. Pakistan asked the IMF to raise their loan from US47.6 billion to US$ 12.1 billion in February 2009. In august 2009 the IMF increases the time span to 25 months and increase the grant to US$11. 3 billion to meet their financial needs.
Ishfaq and Chaudhary (1999)The debt history of Pakistan started in 1984-85, when the surplus revenues turned into a deficit. The fiscal deficit and debt converted into multiple rates. The total deficit rate was Rs 89.2 billion in 1990-91 that rate was increased to 66% in 1997-98 and approximately to Rs 148 billion. The domestic debt was increased to 185 percent the amount increased Rs 448 billion to Rs 1280 billion and foreign debt increased to 156 percent the amount was Rs 272 billion to Rs 697 billion in the same time period. Pakistan has an opportunity to do some measures for the establishment of the macroeconomic indicator rather than to go for deficit financing for generating the revenue. In the mid of the 2008 the Pakistan started registering the imbalance in the overall economy. At the end of the 2008 the Pakistan fiscal deficit was increased to $ 5.6 billion that exceed to $ 8 billion. The trade deficit also increases to $ 13 billion to $ 18 billion. Foreign reserve has fallen to decrease to $ 6.5 billion. (Baig, 2011) Pakistan forced to take the help from the IMF in order to get financing for the deficit finance of their economy. The help provided by the IMF was the package of $6.7 billion that was later increased to $ 11.3 billion in 2009. The IMF also helped Pakistan by providing bilateral and multilateral aid that also causes to increase external debt and liabilities to $ 54 billion from $ 41 billion in January 2008. Pakistan is also used to sovereign bonds and sindak bonds in order to use another form of deficit financing. This also creates a problem for a country to repurchase these bonds according to their specified time table or schedule because different countries have different foreign currencies. In these situation investors does not show their concern toward the investment. (Baig, 2011). These both measures are taken by the international market that is not so enough for the needs of the Pakistan and then government compelled toward the third mode of deficit finance monetization. The Pakistani government relies on the domestic borrowing that is the cause of disparities in the debt dynamics. The domestic debt borrowing increased to 24% in the mid of 2008. Pakistan domestic debt was multiplied from Rs 2610 to Rs 4490 in the fiscal year of 2007.At the end of March 2010 Pakistan domestic debt was $ 53.2 billion which was appoximately30.6% of GDP. All the source of the deficit finance is failing to attain the desired results and lead the economy toward the negative direction. By the mid of 2010 Pakistan’s total domestic debt reached to $ 100 billion and there is already paid interest about $5.6 billion and debt servicing amounted $ 7.6 billion annually that was expected to cross the limit of $ 10 billion after the fiscal year of 2010-11. Deficit finance works only when there are such sound policies that direct the planners that how to spend money in a way that raise debt, generate revenues and also plan some actionable ideas that directs that how to repay the debt. For the attainment of all these targets there should be a need of honest and sincere governors that Pakistan does not have. In this way we are able to increase the debt and raising the liabilities that is useful for the upcoming generation to pay off that. The money that is used to spend on the future of the Pakistani people should also be spent on the future of Pakistan that could be served as the bureaucracy, foreign visit, and corruption and government functionaries.
Today the Pakistan debt situation is alarming and we have no plans that how to raise sustainable revenues and having no idea that how to accumulate the external and domestic debt. We have very few and tough choices to make serious and valuable decisions. The main causes of deficit financing in Pakistan are: Increase in government expenditure: The government expenditures both development and non-development are increasing as time passes. The government has not been able to meet the expenditure by its revenues. Ineffective budget deficit: There are ineffective fiscal policies implemented in Pakistan and fiscal indiscipline also result the public debt. Fiscal deficit: The average fiscal deficit in 1990s was 7% of GDP. The public debt increased from 66% of GDP in 1980 that almost 100% by the mid of 2000. In 2004-2005 the fiscal deficit was 3.3% of GDP however; it increased to 4.2% in 2006-2007. Low saving: The people of Pakistan are consumption oriented. Due to high consumption rate the saving ratio was lower than 16%. Rapid population growth: The rapid population growth also a main cause to slow down the economic activity of a country. According to economic survey of 2007-2008 the population growth was 1.8%. In underdeveloped countries the increase in money supply is one of the major causes of disequilibrium in the balance of payment with heavy government borrowing from banks and as well as from international source of finance. In such developing countries government relies on the deficit financing due to unable to use their domestic sources due to the inflexible tax structure. The capital market of such underdeveloped nations is not able to determine the interest rate and the interest rate was determined by the institutions that in case the result of excess money supply.
AIOU Solved Assignment 1 Code 808 Spring 2021
Q.3 Discuss various types of benefits and costs of any public project.
Once decisions have been made on how the limited national budget should be divided between different groups of activities, or even before this, public authorities need to decide which specific projects should be undertaken. One method that has been used is cost-benefit analysis. This attempts to do for government programs what the forces of the marketplace do for business programs: to measure, and compare in terms of money, the discounted streams of future benefits and future costs associated with a proposed project. If the ratio of benefits to costs is considered satisfactory, the project should be undertaken. “Satisfactory” means, among other things, that the project is superior to any available public or private alternative. Or, if funds are limited, public investment projects may be assigned priorities according to their cost-benefit ratios.
One difficulty with cost-benefit analysis is that every government agency has an incentive to estimate favourable ratios for its own projects. It must, after all, compete with other agencies for funds. No one can be certain as to the returns to be expected from an irrigation canal or a highway. Private investors have also been known to exaggerate their claims in appealing to stockholders, but they are generally subject to market sanctions that encourage them to err on the side of caution.
In addition to the possibility that cost-benefit analysis may be biased by the preformed views of those commissioning the study, there are other, more fundamental difficulties. Almost all proposals have effects that are difficult to value in monetary terms. The siting of a new airport brings problems of noise and property blight to local people and increases the risk that civilians may die in an accident. Putting a sensible value on human life has been a continuing difficulty for those carrying out cost-benefit analyses, even though every project does in fact affect probabilities of life and death. These problems are, of course, not confined to cost-benefit analysis. Additional expenditure on health service or on road safety or better housing or heating old people’s homes in winter all affect the number of people who die prematurely. The failure of cost-benefit analysis to provide answers to the problems of valuing life, or the quality of life, is a reflection of the wider problem confronting all decisions on public expenditure: the influence of subjective judgment. Until the mid-1970s the proportion of economic activity controlled by the government and the share of taxes in national income tended to increase in most countries. Since then, however, challenges to this growth in the role of government have become increasingly influential, and moves to privatization have been common.
There are several types of privatization. One involves the sale to private owners of state-owned assets, and this is most correctly called privatization. Publicly owned houses may be sold to their occupants. Commodity stockpiles may be reduced or disbanded. Increasingly, however, attention has been turned to the sale of publicly owned industries, thus reversing the move to nationalization that occurred, particularly in western Europe, around and after World War II.
Where the privatized industry operates in a competitive environment, no new problems arise. Singapore has privatized its airline system, for example, which now competes with a mixture of privately and publicly owned international airlines. Where privatization occurs but monopoly continues, however, there are new difficulties. Both Japan and the United Kingdom have privatized their telecommunications networks. Although, in certain limited areas of telecommunications, competition is possible—and has been allowed to develop in both the United States and Britain—technical and legal restrictions inhibit competition in many sectors of the industry.
Regulation is necessary, therefore, to restrict the freedom of privatized monopolies, or near monopolies, to raise prices and to exploit consumers in other ways. In the United States, which has by far the longest history of regulating private utilities, such regulation has normally limited the rate of return that they earn to what is considered a fair level. A disadvantage of this is that it may give the industry no greater incentive to increased efficiency than would exist in public ownership, since higher costs can be passed directly onto consumers. There have been experiments, therefore, with other forms of regulation, which seek to strike a balance between incentives for better performance and the ability to exploit consumers.
A further problem for such regulation is that utilities and similar industries normally operate in both competitive and monopoly markets. They may be inclined to use their monopoly power in some areas to gain unfair competitive advantages in others. Despite these difficulties, an increasingly wide range of industries, ranging from water supply to airports, are now considered candidates for privatization.
Privatization can also mean the dismantling of existing statutory restrictions on competition. State activities are often protected by legal prohibitions on competing private enterprise. German railways, for example, are entirely state-owned, and the law not only prevents competing railroads but severely restricts coach services and limits competitive trucking. The dismantling of such restrictions is seen as one method of improving the efficiency of state concerns.
Another demand of privatization is the contracting out of publicly provided services. U.S. municipalities have often entrusted activities such as refuse collection, and in some cases even fire service, to private contractors, and European countries are increasingly experimenting with similar schemes. These possibilities demonstrate that a service may be government-financed but not necessarily provided by the government; if extended more widely, the concept could yield a different view of the economic role of the state.
While the objective of privatization is often to increase the efficiency of government activities, its implementation may also have important effects on government revenue. Any savings that result from lower costs lead directly to lower tax rates. Where budgeting procedures do not distinguish between capital and current transactions, the proceeds of privatization sales provide a once-and-for-all boost to revenues. The availability of this source of funding for state activity has given an artificial attractiveness to privatization, especially in the United Kingdom. If an industry is sold for the present value of its expected earnings and if these earnings are the same in public and private ownership, privatization should have no net impact on public finances. If it is expected to be more efficient in the private sector, government finance, on balance, gains. If it is sold for less than the maximum revenue that would be obtained—and this is often the case, either because of the difficulty of selling assets as large as nationalized industries or because the government wishes to secure a wide dispersion of share ownership—the impact is likely to be negative.
Costs and Benefits
When conducting a standard CBA, or most other forms of CBA, the most important element of data gathering conducted by the researcher is in collecting data on costs and benefits associated with a project or a set of project alternatives.
Types of costs
Various costs are incurred in preparation of, during, and after a project. The exact nature of the costs incurred in a project are dependent on the specific project being appraised. However, there are a number of common costs.
Common costs include:
- Purchase of land/site
- Site preparation
- Externalities (e.g. increased noise pollution during construction)
- Reductions in aesthetic of an area or locale
- Administration/transaction costs
Types of benefits
Various benefits are realised from a project. Obviously these benefits, as with costs, are dependent on the type of project being appraised e.g. a road development project would likely have benefits including time-savings and reduced pollution as a result of reductions in congestion.
Common benefits resulting from projects include:
- Live savings and/or reduced injury
- Reductions in pollution
- Job creation
- Positive (possible multiplier) effect on local/wider economy.
- Aesthetic improvements
- Revenues (from a toll on a road for example)
AIOU Solved Assignment 2 Code 808 Spring 2021
Q.4 Discuss in detail various sources of government revenue.
The following points highlight the nine main sources of government revenue. The sources are: 1. Tax 2. Rates 3. Fees 4. Licence Fee 5. Surplus of the public sector units 6. Fine and penalties 7. Gifts and grants 8. Printing of paper money 9. Borrowings.
Source # 1. Tax:
A tax is a compulsory levy imposed by a public authority against which tax payers cannot claim anything. It is not imposed as a penalty for only legal offence. The essence of a tax, as distinguished from other charges by the government, is the absence of a direct quid pro quo (i.e., exchange of favour) between the tax payer and the public authority.
Tax has three important features:
(i) It is a compulsory contribution, to the state from the citizen. Anyone refusing to pay tax is punished under law. Nobody can object to taxation on the ground that he is not getting the benefit of certain state services,
(ii) It is the personal obligation of the individual to pay taxes under all circumstances,
(iii) There is no direct relationship between benefit and tax payment.
Source # 2. Rates:
Rates refer to local taxation, i.e., taxation levied by (or for) local rather than central government. Normally rates are proportional to the estimated rentable value of business and domestic properties. Rates are often criticised as being unrelated to income.
Source # 3. Fees:
Fee is a payment to defray the cost of each recurring service undertaken by the government, primarily in the public interest.
Source # 4. Licence fee:
A licence fee is paid in those instances in which the government authority is invoked simply to confer a permission or a privilege.
Source # 5. Surplus of the public sector units:
The government acts like a business- person and the public acts like its customers. The government may either sell goods or render services like train, city bus, electricity, transport, posts and telegraphs, water supply, etc. The government also earns revenue from the production of commodities like steel, oil, life-saving drugs, etc.
Source # 6. Fine and penalties:
They are the charges imposed on persons as a punishment for contravention of a law. The main purpose of these is not to raise revenue from the public but to force them to follow law and order of the country.
Source # 7. Gifts and grants:
Gifts are voluntary contribution from private individuals or non-government donors to the government fund for specific purposes such as relief fund, defence fund during war or an emergency. However, this source provides a small portion of government revenue.
Source # 8. Printing of paper money:
It is another source of revenue of the government. It is a method of creating extra resources. This method is normally avoided because if once this method of financing is started, it becomes difficult to stop it.
Source # 9. Borrowings:
Borrowings from the public is another source of government revenue. It includes loans from the public in the form of deposits, bonds, etc. and also from the foreign agencies and organisations.
AIOU Solved Assignment Code 808 Autumn 2021
Q.5 Access the effects of inflation on income tax.
Inflation is an economic term describing the sustained increase in prices of goods and services within a period. To some, inflation signifies a struggling economy, whereas others see it as a sign of a prospering economy. Here, we examine some of the residual effects of inflation.
- Inflation, the steady rise of prices for goods and services over a period, has many effects, good and bad.
- Inflation erodes purchasing power or how much of something can be purchased with currency.
- Because inflation erodes the value of cash, it encourages consumers to spend and stock up on items that are slower to lose value.
- It lowers the cost of borrowing and reduces unemployment.
1. Erodes Purchasing Power
This first effect of inflation is really just a different way of stating what it is. Inflation is a decrease in the purchasing power of currency due to a rise in prices across the economy. Within living memory, the average price of a cup of coffee was a dime. Today the price is closer to three dollars.1
Such a price change could conceivably have resulted from a surge in the popularity of coffee, or price pooling by a cartel of coffee producers, or years of devastating drought/flooding/conflict in a key coffee-growing region. In those scenarios, the price of coffee products would rise, but the rest of the economy would carry on largely unaffected. That example would not qualify as inflation since only the most caffeine-addled consumers would experience significant depreciation in their overall purchasing power.
Inflation requires prices to rise across a “basket” of goods and services, such as the one that comprises the most common measure of price changes, the consumer price index (CPI). When the prices of goods that are non-discretionary and impossible to substitute—food and fuel—rise, they can affect inflation all by themselves. For this reason, economists often strip out food and fuel to look at “core” inflation, a less volatile measure of price changes.
2. Encourages Spending, Investing
A predictable response to declining purchasing power is to buy now, rather than later. Cash will only lose value, so it is better to get your shopping out of the way and stock up on things that probably won’t lose value.
For consumers, that means filling up gas tanks, stuffing the freezer, buying shoes in the next size up for the kids, and so on. For businesses, it means making capital investments that, under different circumstances, might be put off until later. Many investors buy gold and other precious metals when inflation takes hold, but these assets’ volatility can cancel out the benefits of their insulation from price rises, especially in the short term.
Over the long term, equities have been among the best hedges against inflation. At close on Dec. 12, 1980, a share of Apple Inc. (AAPL) cost $29 in current (not inflation-adjusted) dollars. According to Yahoo Finance, that share would be worth $7,035.01 at close on Feb. 13, 2018, after adjusting for dividends and stock splits. The Bureau of Labor Statistics’ (BLS) CPI calculator gives that figure as $2,438.33 in 1980 dollars, implying a real (inflation-adjusted) gain of 8,346%.2
Say you had buried that $29 in the backyard instead. The nominal value wouldn’t have changed when you dug it up, but the purchasing power would have fallen to $10.10 in 1980 terms; that’s about a 65% depreciation. Of course not every stock would have performed as well as Apple: you would have been better off burying your cash in 1980 than buying and holding a share of Houston Natural Gas, which would merge to become Enron.3
3. Causes More Inflation
Unfortunately, the urge to spend and invest in the face of inflation tends to boost inflation in turn, creating a potentially catastrophic feedback loop. As people and businesses spend more quickly in an effort to reduce the time they hold their depreciating currency, the economy finds itself awash in cash no one particularly wants. In other words, the supply of money outstrips the demand, and the price of money—the purchasing power of currency—falls at an ever-faster rate.
When things get really bad, a sensible tendency to keep business and household supplies stocked rather than sitting on cash devolves into hoarding, leading to empty grocery store shelves. People become desperate to offload currency so that every payday turns into a frenzy of spending on just about anything so long as it’s not ever-more-worthless money.
The result is hyperinflation, which has seen Germans papering their walls with the Weimar Republic’s worthless marks (the 1920s), Peruvian cafes raising their prices multiple times a day (the 1980s), Zimbabwean consumers hauling around wheelbarrow-loads of million- and billion-Zim dollar notes (the 2000s), and Venezuelan thieves refusing even to steal bolívares (2010s).
4. Raises the Cost of Borrowing
As these examples of hyperinflation show, states have a powerful incentive to keep price rises in check. For the past century in the U.S., the approach has been to manage inflation using monetary policy. To do so, the Federal Reserve (the U.S. central bank) relies on the relationship between inflation and interest rates. If interest rates are low, companies and individuals can borrow cheaply to start a business, earn a degree, hire new workers, or buy a shiny new boat. In other words, low rates encourage spending and investing, which generally stokes inflation in turn.5
By raising interest rates, central banks can put a damper on these rampaging animal spirits. Suddenly the monthly payments on that boat, or that corporate bond issue, seem a bit high. Better to put some money in the bank, where it can earn interest. When there is not so much cash sloshing around, money becomes more scarce. That scarcity increases its value, although as a rule, central banks don’t want money literally to become more valuable: they fear outright deflation nearly as much as they do hyperinflation. Rather, they tug on interest rates in either direction in order to maintain inflation close to a target rate (generally 2% in developed economies and 3% to 4% in emerging ones).
5. Lowers the Cost of Borrowing
When there is no central bank, or when central bankers are beholden to elected politicians, inflation will generally lower borrowing costs.
Say you borrow $1,000 at a 5% annual rate of interest. If inflation is 10%, the real value of your debt is decreasing faster than the combined interest and principal you’re paying off. When levels of household debt are high, politicians find it electorally profitable to print money, stoking inflation and whisking away voters’ obligations. If the government itself is heavily indebted, politicians have an even more obvious incentive to print money and use it to pay down debt. If inflation is the result, so be it (once again, Weimar Germany is the most infamous example of this phenomenon).
Politicians’ occasionally detrimental fondness for inflation has convinced several countries that fiscal and monetary policymaking should be carried out by independent central banks. While the Fed has a statutory mandate to seek maximum employment and steady prices, it does not need a congressional or presidential go-ahead to make its rate-setting decisions. That does not mean the Fed has always had a totally free hand in policy-making, however. Former Minneapolis Fed President Narayana Kocherlakota wrote in 2016 that the Fed’s independence is “a post-1979 development that rests largely on the restraint of the president.”10
6. Reduces Unemployment
There is some evidence that inflation can push down unemployment. Wages tend to be sticky, meaning that they change slowly in response to economic shifts. John Maynard Keynes theorized that the Great Depression resulted in part from wages’ downward stickiness. Unemployment surged because workers resisted pay cuts and were fired instead (the ultimate pay cut).11
The same phenomenon may also work in reverse: wages’ upward stickiness means that once inflation hits a certain rate, employers’ real payroll costs fall, and they’re able to hire more workers.
7. Increases Growth
Unless there is an attentive central bank on hand to push up interest rates, inflation discourages saving, since the purchasing power of deposits erodes over time. That prospect gives consumers and businesses an incentive to spend or invest. At least in the short term, the boost to spending and investment leads to economic growth. By the same token, inflation’s negative correlation with unemployment implies a tendency to put more people to work, spurring growth.
This effect is most conspicuous in its absence. In 2016, central banks across the developed world found themselves vexingly unable to coax inflation or growth up to healthy levels. Cutting interest rates to zero and below did not seem to be working. Neither did the buying of trillions of dollars worth of bonds in a money-creation exercise known as quantitative easing.
This conundrum recalled Keynes’s liquidity trap, in which central banks’ ability to spur growth by increasing the money supply (liquidity) is rendered ineffective by cash hoarding, itself the result of economic actors’ risk aversion in the wake of a financial crisis. Liquidity traps cause disinflation, if not deflation.14
In this environment, moderate inflation was seen as a desirable growth driver, and markets welcomed the increase in inflation expectations due to Donald Trump’s election. In February 2018, however, markets sold off steeply due to worries that inflation would lead to a rapid increase in interest rates.15
8. Reduces Employment, Growth
Wistful talk about inflation’s benefits is likely to sound strange to those who remember the economic woes of the 1970s. When growth is slow, unemployment is high, and inflation is in the double digits, you have what a British Tory MP in 1965 dubbed “stagflation.”
And yet even dollar devaluation does not fully explain stagflation since inflation began to take off in the mid-to-late 1960s (unemployment lagged by a few years). As monetarists see it, the Fed was ultimately to blame. M2 money stock nearly doubled in the decade prior to 1970, nearly twice as fast as the gross domestic product (GDP), leading to what economists commonly describe as “too much money chasing too few goods,” or demand-pull inflation.
Supply-side economists, who emerged in the 1970s as a foil to Keynesian hegemony, won the argument at the polls when Reagan swept the popular vote and electoral college. They blamed high taxes, burdensome regulation, and a generous welfare state for the malaise; their policies, combined with aggressive, monetarist-inspired tightening by the Fed, put an end to stagflation.
9. Weakens or Strengthens Currency
High inflation is usually associated with a slumping exchange rate, though this is generally a case of the weaker currency leading to inflation, not the other way around. Economies that import significant amounts of goods and services—which, for now, is just about every economy—must pay more for these imports in local-currency terms when their currencies fall against those of their trading partners.
Say that Country X’s currency falls 10% against Country Y’s. The latter doesn’t have to raise the price of the products it exports to Country X for them to cost Country X 10% more; the weaker exchange rate alone has that effect. Multiply cost increases across enough trading partners selling enough products, and the result is economy-wide inflation in Country X.
But once again, inflation can do one thing, or the polar opposite, depending on the context. When you strip away most of the global economy’s moving parts it seems perfectly reasonable that rising prices lead to a weaker currency. In the wake of Trump’s election victory, however, rising inflation expectations drove the dollar higher for several months. The reason was that interest rates around the globe were dismally low—almost certainly the lowest they’ve been in human history—making markets likely to jump on any opportunity to earn a bit of money for lending, rather than paying for the privilege.