Observations & Notes

Archive for October, 2014

Economic Effects of Inflation

The following are some of the consequences of inflation on a very high level.

  • Loss of Purchasing Power: an increase in prices imply reduced purchasing power of the currency. As prices rise, each monetary unit buys fewer goods and services as prices rise. Increase in the price levels erode the real value of money. Individuals or institutions with cash savings will suffer with the price inflation. High inflation may reduce the incentive to save.

  • Wealth Redistribution: The effect of inflation is not distributed evenly in the economy. It redistributes income from people on fixed incomes to people on variable income that rises with inflation. Few people benefit from inflation such as asset price inflation – eg., value or price of a physical asset, a property, going up. At the same time, few people who seek to acquire the physical asset will need to pay more for the same property. In US, the Fed induced Quantitative Easing (QE) programs created massive asset price inflation in financial markets and real estate in recent years. It is not so surprising to hear chatter about “income inequality” these days.

    Another example is the impact of inflation on lenders and borrowers. Unexpected inflation usually hurts lenders and helps borrowers as lenders receive paid back money that is worth less than what they lent out while borrowers will be paying back loans that are worth less than they were at the time of borrowing. This is one of the reasons Wall Street is more concerned about inflation than the individual with average standard of living.

    Inflation

  • Uncertainty and Confusion: when inflation is high, people are uncertain what to spend their money on. Prolonged period of high inflation discourage businesses from investing because they are uncertain about future profits and costs. During inflationary periods, investors may not be interested in buying debt instruments issued by a country such as bonds as they are denominated in the currency that is being devalued due to the inflation. This uncertainty and confusion can lead to stalled or lower rates of economic growth over the long term.

  • Decline in Global Competitiveness: increased production costs due to inflation make exports cost more abroad causing a drop in demand for exported goods. That in turn can lead to a decrease in demand for the currency, and initiate ripple effects in economy and monetory policy to devalue the underlying currency.

    While devaluation may restore competitiveness – hence exports, it imports inflation by making the import costs rise in proportion. Rising exports combined with expensive imports can cause consumers and firms to purchase domestic goods driving the aggregate demand to increase triggering demand pull inflation. Also with devalued currency, businesses are less motivated to cut unnecessary costs.

  • Boom-Bust Cycles: boom and bust business cycle involve a rapid economic growth on the heels of high inflation followed by a period of economic contraction or recession.

    Boom cycles are usually triggered by loose monetary and fiscal policies with cheap credit and ample money supply. This leads to a rapid rise in economic growth mainly due to higher consumer spending coupled with lower savings pushing aggregate demand upwards consequently causing inflation in all kinds of asset classes. However this kind of rapid boom is unsustainable. Furthermore decline in savings ratio could create an unstable economy. As consumers and lenders start reducing the debt and start saving, the deleveraging process can lead to a slowdown in economic growth which can turn into recession.

  • Bracket Creep and Fiscal Drag: growth in nominal earnings due to inflation may push or drag more tax payers into higher tax brackets resulting in higher income taxes at the expense of minimal or no real increase in purchasing power. Many tax systems are not adjusted for inflation, and income tax codes typically take a longer time to change. As a result, government’s tax revenue rises without explicitly raising tax rates. However with slow government action or unchanged tax policies, people pay higher average and marginal tax rates over time consequently leading to deflationary pressure or drag on the economy due to the lack of demand for goods and services.

  • Menu Costs: when inflation is high, prices frequently change prompting firms and businesses to update price catalogs at the same pace. These adjustments require both time and money. The cost resulting from changing the prices is usually referred as menu costs. Modern technology may help reduce the menu costs, but still it is a cost and inconvenience that is a side effect of high inflation.

  • Opportunity cost of time and energy that individuals spend trying to counteract the effects of high inflation such as searching for good prices, savers holding less cash to keep much of their money in interest bearing accounts and/or to invest in different asset classes with lower levels of inflation etc., This type of cost was historically referred as Shoe Leather Cost.

  • Shortage in Goods: when prices go up too frequently, consumers will buy and hoard durable, non-perishable commodities and other goods including food items to avoid the losses expected from further decline in purchasing power of money, creating shortages of the goods.

    As of this writing, Venezuela’s annual inflation rate is at more than 60%, and long lines at grocery stores is a common sight due to the shortage of food and other supplies.

  • Social Unrest and Revolutions: Inflation can lead to massive demonstrations and revolutions. In recent history, food price inflation caused Tunisian and Egyptian revolutions in year 2011.

  • Hyperinflation: under extreme circumstances, if inflation becomes too high, people may curtail the use of their currency. It can lead to an acceleration in the inflation rate, referred as hyperinflation, which interferes with the normal workings of the economy. Ultimately the nation experiencing hyperinflation may abandon its currency as witnessed by the abandonment of Zimbabwean Dollar by Zimbabwe in year 2009.

Source & References:
Various www sources including investopedia, wikipedia, economicshelp.org

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