Effect of inflation

inflation affects the different sectors of the economy differently. in general, effects of inflation
seem to be negative. but if the rate of inflation is low, then this provides some motion to the
economy. this sort of motion increase the employment and leads the economy towards
development and prosperity. but, when the rate of inflation is high, then this will affect the
economy negatively. this will hinder the capital formation as well as create the black market and
artificial scarcity with decrease in the quantity of goods. if the income of people increases in
proportion to the increase in the price of goods, then this is not regarded as harmful. but if the
price and income do not increase proportionately in the economy, then this will affect different
sectors of the society differently. the sector having fixed income will be affected more than the
other sectors, thus, effects of inflation can be explained more clearly by dividing them into two
part. they are :
1. economic effects
2. non-economic effects
1. economic effects of inflation
economy is deeply affected by inflation. the economic effects of inflation can be divided into two
parts. they are:
i. effects on production
creeping inflation has positive effect in the economy because in the beginning the increase n
price is very small. in such situation, due to small increase in the cost of production, the profit
also increases by a small scale. this affects the economy positively. when hyper inflation occurs
in the economy, then due to uncertainly there will be negative effect in production. therefore,
hyper inflation is harmful to the economy. the negative effects on production can explained as
follows:
(1) disrupts in price system: inflation will disrupt the price system which will increase slowly. as
a result if this the factors won't be mobilized properly.
(2) discourage to foreign capital: inflation not only decrease the saving of domestic capital, it
also result in the devaluation of money . as a result, there won't be profit for the foreign investors
and this will discourage the foreign capital investment.
(3) reduction in capital accumulation: inflation badly affects saving and capital formation
because high price needs to be paid for the goods when price increase. as a result there won't be
any saving and sources of investment will be closed.
(4) encourages hoarding: when prices increase people will increase the stock to create artificial
scarcity in order to earn more profits. from this , the businessmen specially the black marketers
will make excessive profits. due to fear of further increase in price people will start hoarding
more goods and this will increase the price even more.
(5) encouragement to speculation activities: inflation encourages speculation activities withe
further increase in prices. businessmen instead of producing proper goods for earning profits,
shift to easy and fast profit making activities.
(6) reduction in the volume of production: inflation reduces the volume if production in two

ways. firstly, there won't be any capital formation due to lack of saving. secondly, due to
uncertainty in the business, the producers are not ready to bear risks. therefore, there will
reduction in the volume of production.
(7) effects on the pattern of production: hyper inflation brings about the change in the pattern of
production. due to inflation, income of some people will increase comprehensively while income
of some other people will decrease. people with increased income will demand for luxury goods
in greater quantity. therefore, production of luxury goods will increase and the production of
necessary goods will decrease.
(8) decrease in quality: in the state of inflation, the inflation of the sellers in the market will
increase. as a result, to earn more profit, they will reduce the quality of the goods.
ii.effects on distribution of wealth
inflation badly affects on the distribution of wealth. when price increases in the economy, some
class ofthe society will benefit and some class will face loss. in any society, there will be two
classes of people. one having constant income and the other having variable income. if the
inflation prevails for a long period then businessmen, industrialists and rich people will become
even richer while the poor class and people with fixed income ( servicemen, teachers, people
dependent on pension and some kind of rent) will become poorer facing even worse situations.
so, effects of inflation on different people of the society are as follows:
(1) debtor and creditor: when price increases, the debtor will benefit and the creditor will suffer
loss. when price increases, then the value of money will decrease. the money returned by the
debtor will be able to purchase less quantity of goods and services than before. what is clear from
this is that, the value of money is more at the time if taking loan and the value of money is less at
the time of returning the loan. therefore, debtor will have some sort of benefit and the creditor
will have some loss during the time of inflation.
(2) wage and salary earners
daily wage earners and salary earners are affected more by inflation. there are mainly two
reasons for this. firstly wage and salary do not increase in proportion to the increase in price.
secondly, the gap between the increase in price and the increase in wage and salary will become
even wider. in such a situation, labors and servicemen not associated with labor union will be
affected more. that is . they will suffer more loss.
(3) fixed income earner group: people dependent on fixed income, such as pension, house- rent
and previous saving will be affected by inflation. thus is, inflation will harm the people having
fixed income. but people having variable income, such as, industrialists, businessmen and shareholders will benefit from inflation . the income of such people will increase during the time of
inflation.
(4) business community: all types of business communities, such as producers businessmen,
entrepreneurs, speculation group etc, earn profit deuing the time of inflation. to earn more profit
in short period. they will increase the price of goods more than the increase in the cost of
production of such goods. similarly , since the value of the assets of such people increase such
communities will be in profit.
(5) investors: investors are affected by inflation in two ways because there are two types of
investors. the first type of investors are those having fixed income and the other type having
variable income. investors with fixed income are those who earn income at a fixed rate as

interest for providing their capital for investment. such a investors are not affected by the profit
or loss in th business. in such situation excessive increase in the price of the goods will decrease
the purchasing power. contrary to this, investors having variable income will benefit from
inflation because they share the profits and losses of the industry,if profit is resulted, then their
profit will also increase proportionally. since level of profit is more during the time of inflation ,
the income of the investors will also be more because they will get their shares.
(6) farmers: normally, price of the goods is more than the cost of production during the time of
inflation. for this reason the farmers are also benefited. but Small farmers won't be able to share
this benefit. small farmers normally don't produce goods for selling in the markets. as a result,
they will have to purchase some goods for consumption.
2. non-economic effects of inflation
due to excessive increase in demand during the time of inflation, the production and employment
also increase. this will benefit the debtors, producers and business communities. but, this does
not mean that the effects of inflation are always good. inflation harms the consumers, investors
and creditors . as a result inflation also has various non-economic effects.
" non -economic effects" means crisis in social, political and moral sectors. corruption, black
market, bribery, etc. are resulted due to inflation. the government. so, the effect of inflation is
economically unsound, politically dangerous and socially as well as morally disastrous. noneconomic effects of inflation can be explained as follows:
(1) social effects : inflation has various effects in the society. inflation makes rich people even
richer and poor people even poorer. as a result of this , conflict starts between the rich class and
the poor class.
(2) moral effects : inflation negatively affects the morality of people. as a result of this, black
market, bribery and corruption will increase in the society. this will provide protection to the
speculation activities. with the objective of earning more profits businessmen will mix goods
with inferior goods which will even reduce the quality of goods.
(3) political effects: inflation not only has economic, social and moral effects but it also has
political effect. during the time of inflation, people will be dissatisfied with the government. as a
result, unhealthy competition will start in politics. opposition parties try to become ruling body
by heavily criticizing the government and turning the people against the government. they try all
means to remove the ruling government. the inflation of 1920 in Germany made Hitler a dictator

Theories of Inflation and its Economic Consequences

Since its specifically difficult to identify the reasons for or factors that contribute to
inflation, many theories and concepts have been introduced for this purpose. Each
theory tries to clarify the supply and demand factors that result in the creation of an
inflationary situation.
The main theories of inflation are as follows,

Quantity Theory of Money

Keynesian Theory

Monetarism

Structuralism

Quantity Theory of Money

This refers to the identical or equal relationship between national income estimated
at market prices and the velocity of circulation of the money supply. Based on this
theory, there is a positive relationship between price levels and the money supply.
This relationship is presented using the quantity equation (MV=PY) which was
observed previously under the study on money supply.
MV = PY
Where: M is the stock of money in circulation
V is the velocity of circulation
P is the general price level
Y is the total income.
Accordingly there will be a proportionate positive relationship between the money
supply and the price levels of a given economy. That is, when the money supply
increases by a certain percentage the price levels will also increase by an equal
percentage.
According to this theory it is believed that inflation is caused by an expansion in the
money supply of a given economy. It is under the view that inflationary situations
caused due to an increase in money supply which is not followed by or supported by
an increase in output levels of an economy.

Keynesian Theory
The Keynesian view on inflation initially introduced in a book titled The General
Theory of Employment, Interest and Money published in 1940.
According to Keynes an increase in general price levels or inflation is created by an
increase in the aggregate demand which is over and above the increase in
aggregate supply. If a given economy is at its full employment output level, an
increase in government expenditure (G), an increase in private consumption (C) and
an increase in private investment (I) will create an increase in aggregate demand;
Leading towards an increase in general price levels.
Such an inflationary situation is created due to the fact that at optimum or full
employment of output (maximum utilization of scarce resources) a given economy
is unable to increase its output or aggregate supply in response to an increase in
aggregate demand.

According to the graph, when the government uses monetary and fiscal policies to
improve full employment of production levels, there will be an increase in aggregate
demand level of the economy from AD0 toAD1 which would result in the creation of
full employment level of equilibrium out put represented at the point E. If the
aggregate demand level increases further from AD1 to AD2 the general price levels
shall increase since the full employment of production level will remain unchanged
at Yf. The output level will not change since all resources are fully employed at the
point of Yf.
An Aggregate demand level over and above the full employment of production level
will create an inflationary gap of EF. In addition, an aggregate demand below the full
employment of production level will create deflationary gap of ED.

Monetarism
The monetarists theory states that when the money supply is increased in order to
grow or increase production and employment, creating an inflationary situation
within an economy.
A monetarist believes increases in the money supply will only influence or increase
production and employment levels in the short run and not in the long run.
Accordingly, there will be a positive relationship between inflation levels and money
supply. The monetarists explain this relationship using the theory of natural rate of
unemployment.
The theory of natural rate of unemployment suggests that there will be a level of
equilibrium output, employment, and corresponding level of unemployment
naturally decided based on features such as resources employment, technology
used and the number of firms in the country etc, the unemployment level decided in
this manner will be identified as natural rate of unemployment.
In the short run, expansionary monetary policies will result in the decline in the
natural rate of unemployment and increase the production but the effectiveness of
the expansionary policies will be limited in the long run and lead to an Inflationary
situation.

Structuralism
This theory states that the main reason for inflation is the in-elasticity in the
structures of the economy. This theory is mainly used to explain the nature and
basis of inflation in developing countries. Originating in Latin America, this theory
states that the inflation rates in developing countries are affected by the inelasticity of the following reasons;

Production level and capacity

Capital formulation

Institutional framework

High in-elasticity in the agricultural sector

In-elasticity of the labour force and employment structures.

Economic Consequences
Unfavorable effects

Increase in the cost of living

An increase in the general price of goods and services will increase the cost of living
and lead to a decrease in the living standards of fixed income earners. Such a
situation can create many social, economical, and political problems within a given
country.

Inefficiency in resource utilization

In situations of inflation the aggregate demand for goods and services will decrease
due t the decrease in purchasing power of consumers. Accordingly, output levels
will be affected by a decrease, resulting in an overall reduction of full employment
or resource utilization within the economy. On the other, hand the production of
essential goods can be limited or ignored ignored since many producers will try to
purchase high priced goods with a greater increase in price levels of inflationary
effect and profit.

Savings are discouraged

Savings will be discouraged since the real value of savings declines and the returns
that could be received through other means of investment increases. This is
because the inflation is high than the rate of interest received on the deposits or
savings.

Fixed income earners will be at a disadvantage

Fixed income earners or parties who receive wages, rent and interest income on
previously agreed, fixed term contracts are the parties that are the most adversely
affected by inflation. They are unable to increase their income and the real value of
money continually decreases leading to a decrease in real income of these parties.

Long-term investments will be discouraged

There will be low levels of domestic and foreign investments due to the economic
and political instability created by high levels of persistent inflation within the
economy. On the other hand, speculators and investors tend to invest more on real
assets than financial assets, which will lead to low levels of fund formation for
business activities and long-term investments

Increased Government spending

The governments current and capital expenditure will increase in time inflation,
since the government income remains unchanged or decreases, the budget deficit
expands further. the government needs to provide assistance in terms of fund
transfers to low and fixed income earners and if the government finances such
expenditure using borrowings from banking sources, further inflationary pressure
will be created.

Inflation creates adverse effects on the Balance of Payment and Foreign

Exchange Reserves of a country.

High levels of domestic inflation can over value the foreign exchange rates of
a country resulting in unfavourable situations in international trade.

Favourable effects

The producers, businesses, and organizations will benefit from inflation,

since the price levels of goods and services will increase at a higher level that
the cost of production, thereby increasing profits.

Debtors shall benefit at the expense of creditors as the real value of loan
installments and interest rates falls in situations of inflation.

An inflationary situation can stimulate or assist in the process of achieving

economic growth since producers are encouraged with the increase in profits,
resulting in the expansion of business activities.