Economic Impact of Inflation

There are many deadly effects of inflation. Two of the most important are:

Redistribution of Wealth and Income among the People Distortion in the Production of Goods, employment and relative Prices (During Periods of Inflation all prices and wages do not change at the same rate; so changes in relative prices occur)

Impact on Wealth and Income

This effect is focused on the assets and liabilities of the People. If you owe money, a rise in the price will be a gain for you . But you lend and the prices rise, you suffer. Because the amount repaid to you are not worth as much as you lent. This is called the Redistribution effect of Inflation from Lenders to borrowers.

In conditions when inflation persists for a long time than individuals can anticipate or predict inflation and lenders can act accordingly. Markets adapt to the change and gradually interest rate will be adjusted according to that current inflation rates. In such a cases there are no redistribution effects of Income and wealth particularly when interest rates are settled to the new inflation rate. Lets say the economy runs with 5% in interest rate with stable prices and if there is an expected 7% increase in prices than the interest rates will change to 10% instead of running on the same level. So the counter effects does not generate the redistribution effects.

Conclusion

An unexpected or unanticipated inflation provides an advantage to the debtors while the creditors suffer. While the unanticipated Deflation does the opposite.

Impact on other Macroeconomic Indicators

Inflation not only effects the Wealth and earnings of individuals but also has a negative impact on the economic efficiency of a country. Let us discuss this in detail.

Economic Efficiency

Inflation has an impact on Economic Efficiency because it distorts or fluctuates Prices. In case of predicted inflation people in the market do know about the supply and demand and the price at which the market equilibrates But in cases of high inflation it is very hard to distinguish the changes between different products and their prices. So relative prices provides a false account of decision making.

Additionally Inflation also misshapes the Use of Money. As money loses its value rapidly in cases of high inflation. Individuals are not able to trust money or in other words lose their investment confidence. As a consequence, people prefer to have less money holdings and their trips to banks are more often (See Shoe Leather Concept lecture). So this whole scenario leads to non-productive investment.

Consumers also find the effect of Inflation on Taxes. An increase in Inflation gives you less and less amount or quantity to be bought compared to what you bought before. Because you are paying the same amount of Tax for each product without having an adjustment in your income during inflationary times. So the Real Value of tax that is Paid, INCREASES while the REAL INCOME remain UNCHANGED.

Menu Cost

Some Economists also describe the MENU COST of inflation. It emphasizes that firm need to spend real resources to adjust their prices according to the inflation rates. Say a restaurant have to reprint their menu and catalogs with tax inclusion or exclusion rates. Stores have to change the price tags of their manufactured products.

So how can an economy cure itself ? Shall we reduce inflation to ZERO levels? If NO, than what is the appropriate level to have a smooth running economy ? For answers, Continue reading.

Optimum rate of Inflation in an Economy

You would rather think that after reading all these negative effects of Inflation, it should rather be reduced to the level of ZERO. But even that is not the right solution to all these problems. In case of Labor markets, money wages are reduced in some while increased in other.

Extending my point, a zero inflation would cause a liquidity trap and a negative real interest rate might be required to coup out of recession incase of monetary policy. For the minimization of Liquidity Trap, an economy require positive inflation.

Conclusion

After going through all the analysis, we can conclude that a predictable and expected rise in prices that are slow in its pace can lead to a sustained economic growth. It can be evidently proved that low inflation has lesser negative impact on productivity and output as compared to Galloping and hyperinflation that can harm and redistribute the wealth of people.