Impact Of High Inflation Caused By Massive Money Supply Or Oil Shock

I used to wonder why is it that all the central banks in the world are so afraid of high inflation, and why must they pay so much attention to it. Here’s why:

For a country to be prosperous, its real GDP must be growing consistently. As the country is growing, it will expect inflation, because there will be more demand for goods and services, as everybody has more money to spend. More spending and buying will lead to prices getting higher and higher. It should not be a worrying sign if inflation is controlled at a rate which is lower than the growth of GDP.

However, sometimes due to loose monetary policy, where there is a huge circulation of money supply, such as over lending by the banks, ultra low interest rate; or sudden increase of oil prices due to whatever reasons. The country will experience high inflation, which is a worrying sign.

Lose of Competitive Edge 

Imagine Country A and Country B are both achieving steady economic growth with double-digit GDP growth. However Country A is experiencing inflation at 5 percent, and 10 percent for Country B. Goods and services will appear to be cheaper from Country A as it is experiencing lower inflation.

Assuming that Country B is selling similar goods and services as Country A. Companies in Country B will start to lose their business, and begin job cuts. Ultimately it will leave Country B with high unemployment. Its GDP will contract and embroil in recession.

Country A Country B
Inflation → 5% Inflation → 10%
Goods and Services look cheap Goods and Services seem expensive
Country A is a happy man because it is able to sell more goods and services. Country B is in pain because companies are losing business.

Reduce Household Spending Power

Normally the wages of employees do not always rise as fast as inflation. Because all companies and bosses will definitely want to keep more cash as profit. Imagine if the economy is experiencing an annual inflation of 10 percent, where the annual average employee’s wage rises at a rate of 5 percent.

Household will have less spending power and start to save more money in the banks. Less spending will erode companies’ earnings that are selling goods and services, and eventually lead to high unemployment, and contract the GDP.

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