Effect of Inflation on Exports and Imports - Term Paper Example

? Effect of Inflation on Exports and Imports Inflation delineates a sustained enhancement within the general price level of a national economy appraised either at retail or wholesale level. The costs of inflation are numerous and diverse: inflation devalues money and assets; redistributes income from lenders to borrowers; deteriorates balance of payments; creates uncertainty and plunge in investment; produces money illusion; may lead to unemployment; and misrepresents the price mechanism. Inflation has a significant impact on output rendering significant costs for economy, consumers and producers. Similarly, inflation makes productive investment to drop since profitability plunges, speculative investment increases, which possess a negative impact on employment, output, and income. Inflation makes reserves to be misallocated. The paper explores how influence impacts on trade among nations, especially its effect on exports and imports. Effect of inflation on exports and imports Introduction Inflation refers to the decrease in the value of money as the prices of goods and services gradually increase overtime. Moderate forms of inflation are conceived normal in the majority of economies and desirable in any economy since this is indicative to producers that there is an increasing demand and so stimulates enhanced production, and ultimately economic growth (Evans, 2004). Nevertheless, high inflation, is worrying since the prices of goods and services rise faster that the surge in wages, thus eroding real incomes. Inflation renders exports to fall, as it costs other countries more to purchase similar amount the same goods. This relationship can be outlined mathematically by the equation NI= C+ I+ G- NX whereby NI represents national income (or price level that equates to inflation), C represents consumption (consumer spending) I represent investment; G represents government spending while NX represents net exports. Inflation influences the current account deficit since then demand for exports plunges as prices rise, and imports become more competitive if imports prices reduce comparatively lower to domestic competitors (Ulke & Ergun, 2011). If the country is exporting and the local currency becomes strong, then the country’s products become more expensive for its buyers. If a country is relying heavily on imports and the local currency becomes weak, then the products that are imported becomes expensive (Evans, 2004). As such, inflation increases will lead to deterioration of balance of payments since domestic inflation stimulates import spending provided that imports emerge comparatively cheaper, and diminish export sales, as exports emerge more expensive abroad (Levi, 2009). The association between inflation and exchange rate appears as a double-edged sword whereby the rising inflation tends to render a currency to depreciate (owing to the reduced demand for the country’s demand). Mostly, depreciation aids exporters since prices paid by the overseas buyers decrease (Ulke & Ergun, 2011). Nevertheless, depreciation signifies that prices of imports increase, which is inflationary. The net impact of the devaluation in inflation hinges on the comparative price elasticity of imports and exports. Effects of Inflation on Imports and Exports Exchange rates bear a significant effect on a country’s economy. If the exchange rate drops, this alters the comparative prices of imports and exports. Exports are likely to become comparatively cheap in other currencies while imports become expensive. For instance, when the U.S. purchases imports, the imports are incorporated into the retail price index. In the event that the price of import rises, this could be inflationary, especially in cases where a country’s imports feature a lot of raw materials and semi-finished products (Levi, 2009). A gradual rise in prices will impact on a country’s trading performance mainly on the ration between imports and exports. The performance of a country’s export is an estimate of a country’s competitiveness comparative to other countries (Evans, 2004). If the prices of the exports increase due to inflation, this will yield a fall in international demand, which subsequently impact negatively on the economy in the long run. Inflation can be said to possess two critical negative effects: (1) it restructure income from individuals on fixed incomes (that fail to increase with inflation) to individuals on variable incomes (that rise with inflation). Since the majority of individuals with fixed incomes are poor (for instance, are beneficiaries of social benefits that fail to rise in sequence with inflation), and individuals with variable incomes are comparatively richer, the impact of income centers on redistributing from the poor to the rich (Lipsey & Harbury, 1994). Most importantly, inflation eats into international competitiveness of countries as exports costs high abroad. This may lead to a decrease in demand for exports, which subsequently can yield a decrease in demand for the currency and to a depression of the currency (Ulke & Ergun, 2011). The devaluation may reinstate exports, but at the rate of rendering imports to be more expensive, therefore, making inflation rise again. For instance, if the U.S. was to experience higher inflation levels compared to the rest of the world, all other things held equal, the U.S. exports will be rendered less competitive within the world markets versus similar products from another country. A country is disadvantaged when its domestic inflation is at an enhanced level relative to its competitors. This, in turn, will lead to an adverse impact on output and employment levels within the economy’s export-producing sector (Cherunilam, 2008). With prices increasing more quickly within the U.S., imports turn out to be comparatively less expensive. This makes U.S. Internationally uncompetitive, besides leading to an increase within current Account deficits. Consequently, U.S. buyers will purchase fewer domestically manufactured goods and services and higher imports (Lipsey & Harbury, 1994). The rise in imports possesses an adverse impact on output and employment within the economy’s import-competing sector. Therefore, a higher inflation rate within the U.S. compared to the rest of the world minimizes U.S. exports and enhances U.S. imports (a lower inflation rate possibly has the opposite effect) (Cherunilam, 2008). The government may stiffen fiscal and monetary policies to minimize inflation, therefore, causing unemployment to increase and production to decrease. Overtime, the currency (the dollar) will depreciate in value in terms of foreign currencies (Anderson, 1977). The decrease in value of the dollar will compensate for the increased inflation rate within the U.S. Although, it may take considerable time exports become increasingly affordable to foreign buyers and imports become less appealing to domestic purchasers. The overvaluation of national currencies is not the only potential source of the hypothesized links between inflation, growth, and exports. High inflation may also render a distortion of productivity by forcing a wedge between the returns to real and financial capital. Furthermore, it may minimize saving and the quality of investment by minimizing real interest rates (Buultjens, 2005). The association between the exchange rate and inflation is highly intricate, and it incorporates interactions via several transmission channels within the economy such as trade, domestic demand, financial markets, liquidity and monetary conditions, and cost of production. Rapid inflation can impede on exports and growth via one of the outlined channels (Levi, 2009). The general price inflation mirrors changes within the level and distribution of real income in distribution of real income within countries and across national boundaries. Furthermore, inflation tends to influence currency exchange rates and international balance of payments accounts. A devaluation yields to a reduction in the value of a currency rendering exports to be more competitive and imports more expensive. Inflation transpires when there is a rise in the general price level. The effect of inflation in eroding international competitiveness of countries makes most governments place controlling inflation the fundamental pillar of their economic policy. If the amount of imports increases, this yields a reduction in domestic demand drive, pull inflation represented by the equation (AD= C+ I+ G+X-M) (Moomaw et al., 2010). Devaluation can lead to inflation for three core reasons: first, there is the probability to be an enhancement in AD since if exports are cheaper there is possible to be more exports sold and the amount of imports will fall. Nevertheless, increased AD may not yield inflation it depends on diverse factors: (a) if the economy is experiencing a downturn and there is additional capacity an increased in AD will yield inflation; (b) if related components of AD are not rising (for instance, when consumer spending is low) then there low probability for demand pull inflation; and, (c) is exports are low-priced then the impact on AD hinges on the elasticity of demand (Anderson, 1977). Increases within inflation prospects can be followed by exchange rate depreciation since the monetary authority purchases foreign currency to maintain purchasing power stable. Concerning exports, inflation is mainly inversely linked to real exchange rates given that nominal exchange rates do not change directly to prices, even if inflation may hinder exports and growth via other channels, as well (Buultjens, 2005). The inflation experienced by China in 2011 slowed down China’s might export machine as buyers from western multinationals corporations shy away from the higher prices, and forced them to cut back on their scheduled shipments. In contrast, the annual inflation rate within the U.S. has remained comparatively by historical standards (averaging about 1.5%). China’s imposed price controls on food items in mid-November, 2011 failed to limit inflation. China’s $6 trillion economy used to depend heavily on exports for exports for growth. Although, exports still account for close to one-fifth of the economy, China’s economy grown strongly for the last two years mainly owing to the strength of investment-led domestic demand. A localized inflation will enhance the price of all non-traded goods and services, as well as all factors of production. As a result, this raise the price of exportable, but until the exchange rates changes, the dollar price of importable will not change. This in turn, impacts on the volume/quantities of imports and exports (Moomaw et al., 2010). Since non-tradeable and exportable increase in price, imported goods will be comparatively cheaper than they were, and more imports will be purchased. A localized inflation increases the quantity of imports and reduces the amount of exports at any given exchange rate. The impact of rising inflation on exports and imports demonstrates a need to attain a low rate of inflation necessary to maintain manageable trade, and balance of payments deficits and enhanced saving and investment rates to finance long-run economic growth (Evans, 2004). In most cases, a country experiencing high rates of inflation risk suffering instances of low investment, low productivity, enhanced import-dependence and depressed balance of payments. As demonstrated, it is crucial to comprehend the macro dynamic interconnects among inflation, economic growth, and capital accumulation. Inflation leads to numerous distortions within an economy. When the prices of consumables rise, real income of households’ decreases; subsequently, the households cannot buy as much they previously used to purchase (Anderson, 1977). Inflation also dampens economic agents from saving and in the long-term, hence, inflation minimizes economic growth since the economy needs a certain degree of savings to finance investment projects that stimulate economic growth. Conclusion An increase in import spending ceteris paribus minimizes consumer spending on domestic goods and so minimizes domestic inflationary pressure. Nevertheless, frequently an increase in imports transpires since there is an increase in general spending, and the increase in imports mirrors the inflationary pressure within the economy. The other impact details that an increase in imports will ceteris paribus, render depreciation within the exchange rate. This emanates from the fact that domestic firms supply more dollars to be able to purchase imports. The rises experienced within the supply of dollar renders a devaluation of the dollar. Depreciation within the exchange rate renders an increase within the inflationary pressure since imports turns to be more expensive; exports and AD increase, which in turn yields demand-pull inflation, and, firms may possess depressed incentives to cut costs. References Anderson, D. J. (1977). Economics. London, UK: Macmillan. Buultjens, J. (2005). Excel HSC economics. Glebe, N.S.W: Pascal Press. Cherunilam, F. (2008). International economics. New Delhi: Tata McGraw-Hill. Evans, M. K. (2004). Macroeconomics for managers. Malden, MA: Blackwell. Levi, M. (2009). International finance. New York, NY: Routledge. Lipsey, R. G., & Harbury, C. D. (1994). First principles of economics. Oxford: Oxford University Press. Moomaw, R. et al. (2010). Economics and contemporary issues. Mason, OH: South-Western Cengage. Ulke, V. & Ergun, U. (2011). Econometric analysis of import and inflation relationship in Turkey between 1995 and 2000. Journal of Economic and Social Studies 1(2): 69-84. Read More