26 December 2016

Impact of Inflation on macroeconomic variables

Sulthan Academy Impact of Inflation on macroeconomic variables

Inflation is crucial in determining the purchasing value of money. This has its impact in macro level and lets discuss here the impact of inflation over some macro economic factors such as Exchange rate, Export and Import, Interest rate and Unemployment.

Exchange Rate: Persistently higher inflation in a country (say India rupee ₹) relative to the inflation in another country (say US dollar) generally leads to depreciation of a Rupee in India. Depreciation of the currency of India means decrease in the value of the currency of country relative to the currencies of United States. In other words, if India persistently experiences higher inflation than United states, in exchange for the same number of units of Rupee ₹, the residents of India will get fewer units of US dollar $ than before.

Exports and Imports: As stated, relatively higher inflation in a country leads to the depreciation of its currency vis-à-vis that of the country with lower inflation. If the two countries happen to be trading partners, then the commodities produced by the higher inflation country will lose some of their price competitiveness and hence will experience lesser exports to the country with lower inflation. A currency depreciation resulting from relatively higher inflation leads not only to lower exports but also to higher imports.

Interest Rates: When the price level rises, each unit of currency can buy fewer goods and services than before, implying a reduction in the purchasing power of the currency. So, people with surplus funds demand higher interest rates, as they want to protect the returns of their investment against the adverse impact of higher inflation. As a result, with rising inflation, interest rates tend to rise. The opposite happens when inflation declines.

Unemployment: There is an inverse relationship between the rate of unemployment and the rate of inflation in an economy. It has been observed that there is a stable short run tradeoff between unemployment and inflation. This inverse relationship between unemployment and inflation is called the Phillip’s Curve. when an economy is witnessing higher growth rates, unless it is a case of stagflation, it typically accompanies a higher rate of inflation as well. However, the surging growth in total output also creates more job opportunities and hence, reduces the overall unemployment level in the economy. On the flip side, if inflation breaches the comfort level of the respective economy, then suitable fiscal and monetary measures follow to douse the surging inflationary pressure. In such a scenario, a reduction in the inflation level also pushes up the unemployment level in the economy.

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