Effects of Inflation

 

Effects of Inflation

Inflation affects different people differently. This is because of the fall in the value of money. When prices rise or the value of money falls, some groups of the society gain, some lose and some stand in between. Prices of some goods and services rise faster, of others slowly, and of still others remain unchanged. We discuss below the effects of inflation on redistribution of income and wealth, production, and on the society as a whole.

(a) The effects of inflation on different groups of society are discussed below:

(1) Debtors and Creditors: During periods of rising prices, debtors gain and creditors lose. Though debtors return the same amount of money, but they pay less in terms of goods and services. This is because the value of money is less than when they borrowed the money. On the other hand, creditors lose. Although they get back the same amount of money which they lent, they receive less in real terms because the value of money falls.

(2) Salaried Persons: Salaried workers such as clerks, teachers, and other white collar persons lose when there is inflation. The reason is that their salaries are slow to adjust when prices are rising.

(3) Wage Earners: Wage earners may gain or lose depending upon the speed with which their wages adjust to rising prices. If their unions are strong, they may get their wages linked to the cost of living index. In this way, they may be able to protect themselves from the bad effects of inflation. But the problem is that there is often a time lag between the raising of wages by employees and the rise in prices.

 (4) Fixed Income Group: The recipients of transfer payments such as pensions, unemployment insurance, social security, etc. and recipients of interest and rent live on fixed incomes. Pensioners get fixed pensions. All such persons lose because they receive fixed payments, while the value of money continues to fall with rising prices.

(5) Equity Holders or Investors: Persons who hold shares or stocks of companies gain during inflation. For when prices are rising, business activities expand which increase profits of companies. As profits increase, dividends on equities also increase at a faster rate than prices. But those who invest in debentures, securities, bonds, etc. which carry a fixed interest rate lose during inflation because they receive a fixed sum while the purchasing power is falling.

(6) Businessmen: Businessmen of all types, such as producers, traders and real estate holders gain during periods of rising prices. Take producers first. When prices are rising, the value of their inventories rise in the same proportion. So they profit more when they sell their stored commodities. The same is the case with traders in the short ran. But producers profit more in another way. Their costs do not rise to the extent of the rise in the prices of their goods. This is because prices of raw materials and other inputs and wages do not rise immediately to the level of the price rise. The holders of real estate’s also profit during inflation because the prices of landed property increase much faster than the general price level.

(7) Agriculturists: Agriculturists are of three types: landlords, peasant proprietors, and landless agricultural workers. Landlords lose during rising prices because they get fixed rents. But peasant proprietors who own and cultivate their farms gain. Prices of farm products increase more than the cost of production. For prices of inputs and land revenue do not rise to the same extent as the rise in the prices of farm products. On the other hand, the landless agricultural workers are hit hard by rising prices. Their wages are not raised by the farm owners because trade unionism is absent among them. But the prices of consumer goods rise rapidly. So landless agricultural workers are losers.

(8) Government: The government as a debtor gains at the expense of households who are its principal creditors. This is because interest rates on government bonds are fixed and are not raised to offset expected rise in prices. The government, in turn, levies less taxes to service and retire its debt. With inflation, even the real value of taxes in reduced. Thus redistribution of wealth in favour of the government accrues as a benefit to the tax-payers. Since the tax-payers of the government are high- income groups, they are also the creditors of the government because it is they who hold government bonds. As creditors, the real value of their assets declines and as tax-payers, the real value of their liabilities also declines during inflation. The extent to which they will be gainers or losers on the whole is a very complicated calculation.

Conclusion:

Thus inflation redistributes income from wage earners and fixed income groups to profit recipients, and from creditors to debtors. In so far as wealth redistributions are concerned, the very poor and the very rich are more likely to lose than middle income groups. This is because the poor hold what little wealth they have in monetary form and has few debts, whereas the very rich hold a substantial part of their wealth in bonds and have relatively few debts. On the other hand, the middle income groups are likely to be heavily in debt and hold some wealth in common stock as well as in real assets.

(b) Effects on Production:

When prices start rising, production is encouraged. Producers earn wind-fall profits in the future. They invest more in anticipation of higher profits in the future. This tends to increase employment, production and income. But this is only possible up to the full employment level. Further increase in investment beyond this level will lead to severe inflationary pressures within the economy because prices rise more than production as the resources are fully employed. So inflation adversely affects production after the level of full employment.

The adverse effects of inflation on production are discussed below:

(1) Misallocation of Resources: Inflation causes misallocation of resources when producers divert resources from the production of essential to non-essential goods from which they expect higher profits.

(2) Changes in the System of Transactions: Inflation leads to changes in transactions pattern of producers. They hold a smaller stock of real money holdings against unexpected contingencies than before. They devote more time and attention to converting money into inventories or other financial or real assets. It means that time and energy are diverted from the production of goods and services and some resources are used wastefully.

(3) Reduction in Production: Inflation adversely affects the volume of production because the expectation of rising prices along with rising costs of inputs brings uncertainty. This reduces production.

(4) Fall in Quality: Continuous rise in prices creates a seller’s market. In such a situation, producers produce and sell sub-standard commodities in order to earn higher profits. They also indulge in adulteration of commodities.

(5) Hoarding and Black-marketing: To profit more from rising prices, producers hoard stocks of their commodities. Consequently, an artificial scarcity of commodities is created in the market. Then the producers sell their products in the black market which increase inflationary pressures.

(6) Reduction in Saving: When prices raise rapidly, the propensity to save declines because more money is needed to buy goods and services than before. Reduced saving adversely affects investment and capital formation. As a result, production is hindered.

(7) Hinders Foreign Capital: Inflation hinders the inflow of foreign capital because the rising costs of materials and other inputs make foreign investment less profitable.

(8) Encourages Speculation: Rapidly rising prices create uncertainty among producers who indulge in speculative activities in order to make quick profits. Instead of engaging themselves in productive activities, they speculate in various types of raw materials required in production.

(c) Other Effects:

(1) Government: Inflation affects the government in various ways. It helps the government in financing its activities through inflationary finance. As the money income of the people increases, the government collects that in the form of taxes on incomes and commodities. So the revenues of the government increase during rising prices. Moreover, the real burden of the public debt decreases when prices are rising. But the government expenses also increase with rising production costs of public projects and enterprises and increase in administrative expenses as prices and wages rise. On the whole, the government gains under inflation because rising wages and profits spread an illusion of prosperity within the country.

(2) Balance of Payments: Inflation involves the sacrificing of the advantages of international specialization and division of labour. It adversely affects the balance of payments of a country. When prices rise more rapidly in the home country than in foreign countries, domestic products become costlier compared to foreign products. This tends to increase imports and reduce exports, thereby making the balance of payments unfavorable for the country. This happens only when the country follows a fixed exchange rate policy. But there is no adverse impact on the balance of payments if the country is on the flexible exchange rate system.

(3) Exchange Rate: When prices rise more rapidly in the home country than in foreign countries, it lowers the exchange rate in relation to foreign currencies.

(4) Collapse of the Monetary System: If hyperinflation persists and the value of money continues to fall many times in a day, it ultimately leads to the collapse of the monetary system, as happened in Germany after World War I.

(5) Social. Inflation is socially harmful: By widening the gulf between the rich and the poor, rising prices create discontentment among the masses. Pressed by the rising cost of living, workers resort to strikes which lead to loss in production. Lured by profit, people resort to hoarding, black-marketing, adulteration, manufacture of substandard commodities, speculation, etc. Corruption spreads in every walk of life. All this reduces the efficiency of the economy.

(6) Political: Rising prices also encourage agitations and protests by political parties opposed to the government. And if they gather momentum and become unhandy they may bring the downfall of the government. Many governments have been sacrificed at the altar of inflation.