Saturday, May 7, 2011

Effects of Inflation

Effect on Production

During inflation producers try to minimize the risk. Hence a lot of production potential is sacrificed. Goods that are more durable are produced more; as compared to goods that are less durable. This alters the pattern of production.

Inflation gives rise to more speculation and hoarding, which is bad for the economy.

The basic knowledge about the market tends to lose its importance, and producers and consumers have to update themselves constantly.

Production and economic growth gets seriously retarded, as the products, at high prices, may fail to find a buyer.

Wrong anticipations and misallocation of resources lead to loss of profit and growth.

Effect on Distribution of Wealth

Inflation has its own effects on the aggregate demand, which in turn puts its effects on total production and income. Following are the several effects of inflation.

1. As demand for money increases, its price, namely the rate of interest, rises. That brings down the investment.

2. Inflation reduces the total output of the community.

3. As consumers feel insecure during periods of inflation, their desire to save increases. Thus, propensity to save rises.

4. As the value of money falls, and consequently the real value of wealth in the hands of consumers, spending made by the consumers fall.

5. As goods fetch higher prices in the domestic market, it discourages export, and to an extent encourages imports. More imports deplete the foreign exchange reserve of a country.

6. As profit expectation remains high due to high prices, it encourages investment in some way.

Redistribution of income and wealth take place during periods of inflation. Rate of growth of the economy in also reduced. During inflation people do not want to hold the money, whose value is falling. So there may be a conversion into other assets, in the form of bonds, securities or gold and silver. Wages and profits increase relatively more that rent and interest.

People belonging to the fixed income group are the major losers. Their earnings and accumulated savings diminish or get eroded. Debtors try to pay back their past debts in currencies which are of very little value.

Low-income groups suffer the most during inflation.

Effect on Employment

Inflation and unemployment are inter-related. A near full-employment situation with stability of prices is the aim. However measures to control inflation creates unemployment, whereas measures to reduce unemployment gives rise to inflation. It is like a trap. It is considered that a full-employment situation is a country's inflation threshold.

The Philips Curve merges the demand-pull and cost-push inflation and eliminates the distinction between them. It is proclaimed that the society itself chooses the best possible combination of price-level and employment. The least desired combination between the two could thus be eliminated by the society. Thus the Phillips Curve shows the trade-off between level of unemployment and wage-price increase. It is assumed that wage rise percentage is slightly more than price rise percentage. It shows that greater the unemployment, the lesser is the price rise, and vice versa. On the other hand, more the wage rise, less is the level of unemployment, and vice versa.

Social costs of involuntary unemployment are quite obvious. It cannot be ignored. Inflation can ultimately be considered as a severe form of taxation on the economy as a whole.'

Also read: Inflation and Deflation Demand-Pull Inflation Cost-Push Inflation

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