Benefits and Costs of High Inflation for a Government

Some exam questions ask students to assess the possible impact of high inflation on the government. We look at benefits and risks in this short revision video.

Negative effects of high rates of inflation can include:

1. Pressure to raise the value of state welfare benefits including the state pension or out of work benefits
2. High inflation can cause GDP growth to slowdown – leading to lower tax revenues & increased borrowing
3. High inflation can lead to increased market interest rates making government borrowing more expensive
4. High relative inflation can lead to a worsening of international competitiveness causing a fall in exports which can then threaten jobs and forecast GDP growth

Positive effects of high rates of inflation can include:

1. Higher inflation can lead to fiscal drag – this happens when people’s wages / incomes are rising in nominal terms which causes them to pay more in direct and indirect taxation
2. High inflation can cause a reduction in the real value of the government’s existing / outstanding debt
3. The real interest rate on borrowing money might be negative if the nominal yield (E.g. on a government bond) is less than the rate of inflation
4. Moderate positive inflation helps businesses to make higher profits – generating more tax for the government

Evaluation points: Impact on government depends on:

1. Extent to which market interest rates rise e.g. on bond yields for newly issued government debt
2. Extent to which high inflation and falling real incomes leads to an expanding informal economy / higher rates of tax avoidance
3. Extent to which the government is a major employer in the economy and is forced to increase public sector pay and welfare benefits to protect low income families
4. Extent to which rising costs reduces the ability of a government to fund investment projects