Page 22 - PowerPoint Presentation

> Inflation – the most sinister tax of all

As price levels rise – demand for money is normally expected to rise with it. People having

more money is supposed to create additional demand for goods and services. In turn this
will, it is hoped, boost the aggregate demand curve and bring the supply curve back to its

long-term “natural” state. The new, short run, equilibrium is, hopefully, put back on track

albeit with new higher price levels to be paid by the taxpayer.

Below is a list of some important implications that inflation brings upon the economy and

us.

1. The inflation tax

First, inflation is effectively a tax imposed by governments on to all money holders in the

economy. While governments run large deficits and are not profit driven organizations,

they raise money to pay for all spending through inflation. We all gauge our wealth with
the amount of money we hold. In fact, the purchasing power of the money we hold

measures our real wealth. All money holders pay tax in the form of inflation. The more

money you hold the more you have to give up.

Inflation also “robs” genuine investors through capital gains tax. The money you have

earned over a period of years is subject to capital gains tax, which does not include money

erosion caused by inflation.

If you invested in stocks and made £1000 over the year, your income is taxed at a fixed

rate. Inflation has shrunk your £1000 to £900 (if inflation was running at 10% per annum).
However, you still have to pay income tax on your £1000 gain.

2. Fisher effect

Irvin Fisher (1867-1947) noticed a relationship between nominal interest rates and the
rate of inflation. As people tend to anticipate inflation, the nominal interest rate will

reflect inflation expectations in the long run.

We can question the “Money Neutrality Theory” which states that inflation does not
affect the real variable of production function.

If increased money supply affects nominal interest rates, we see distortions in the market

for loanable funds. Loanable funds are the part of production function K (Capital).
National saving becomes an investment and capital for production growth. If interest rates

rise due to inflation, we see less incentive to borrow capital investment thus we

experience lower productivity and growth in the long run.

3. Purchasing power erosion

If the extended amount of money chases a fixed amount of goods and services, it will lead

to higher prices. As money can buy less every day, purchasing power disappears.

“Main stream economists” agree that inflation does not reduce people’s purchasing

power as wages increase hand in hand with prices.

However, according to the “sticky wage theory”, wages tend to remain steady in a