Effects of inflation

Effects of Inflation on Production

• Inflation may or may not result in an increase in production
• As long as the economy does not reach the full employment stage, inflation has a favorable effect on production
• Usually, as the price level increases, profits increase too
• During inflation, businessmen tend to raise the prices of their products to earn better profits
• However, if the wages and production costs start rising rapidly, then this favorable effect of inflation does not last long
• If the inflation in an economy is of the cost-push type, then the inflationary situation usually leads to a fall in production
• There is no direct correlation between prices and output

Effects of Inflation on the Distribution of Wealth

Inflation has the following effects on the distribution of wealth:

• Some people might gain at the cost of others. As the sellers will be able to sell the goods at a higher rate to its customers due to inflation.
• A certain set of people gain because their money income rises faster than the prices
• A different set of people lose because prices rise faster than their incomes during inflation

Effects of Inflation on Different Categories of People

Debtors and Creditors

• During inflation, borrowers tend to gain. Hence, lenders tend to lose.
• Borrowers gain because they repay less in real terms as compared to when they had borrowed the money
• Lenders lose because when they receive repayment of their debts, the real value of their money declines by the amount of increase in the price levels
• In other terms, a borrower receives ‘dear rupees’ but pays back ‘cheap rupees.

Bond and Debenture Holders

• Debenture and Bond Holders earn fixed income on their investments
• Therefore, when the price levels rise, they suffer a reduction in real income
• Beneficiaries of life insurance programs also suffer badly because the real value of their savings deteriorates

Investors

During inflation, businesses have an opportunity to earn good profits. Therefore, people who invest in shares during inflation tend to gain. As the businesses earn higher profits, they usually distribute the profit among investor and shareholders too.

Salaried People and Wage-earners

During inflation, people earning a fixed income face a lot of damage because the rate of increase in wages is always behind the rate of increase in prices.

Therefore, inflation results in a drop in the real purchasing power of people earning a fixed income. Hence, people earning a flexible income tend to gain during inflationary periods.

Profit Earners, Speculators, and Black Marketeers

• During inflation, the profit-earners gain
• Businessmen also raise the prices of their products and earn bigger profits
• Speculators gain by inflation, especially when the prices of factors of production increase too
• Black marketeers tend to gain since the price of products increases with time.

Effect on Developing Countries

Which theory of inflation can explain inflation in developing countries. Of course, the rise in prices has come about as a result of excess of aggregate demand over aggregate supply. In other words, inflation in the developing countries is mainly of demand-pull variety.

However, how this excess demand for goods and services has been caused is issue at dispute. In our view both the Keynesian and Friedman’s views are relevant to explain the emergence of excess demand for goods. To promote rapid economic growth a hunge investment expenditure has been made in India in successive development plans.

If this increase in investment expenditure had been financed by raising resources through taxation, Government borrowings from the public, profits of public undertakings, then the increase in investment expenditure would have been matched by increase in savings with the result that excess demand for goods had not arisen.

As a matter of fact, a good deal of increase in investment expenditure has been financed by deficit financing i.e., through creating of new money by the central bank. Besides, the increase in private investment expenditure has also been financed to a good extent by expansion of credit or demand deposits by the commercial banks.

This increase in investment expenditure for promoting economic growth has been made possible by the expansion in money supply, which as emphasized by Friedman and other monetarists, causes prices to rise through creating excess demand for goods and services.

Thus, it is hard to distinguish whether it is increase in investment expenditure as such or expansion in money supply to finance it which has caused demand-pull inflation in the face of slow growth of output of goods, especially foodgrains and other essential consumer goods. Indeed, both have played a part in causing inflationary situation in India.

What has caused the inflationary pressures in India’s developing economy? To think that only demand-pull factors or excess demand generated by huge budget deficits and huge growth in money supply are responsible for the problem of inflation facing the Indian economy would not be fully correct.

As a matter of fact, both types of factors, namely, demand-pull and cost push factors have operated to cause inflation in India, which crossed the two-digit figure in some years. As a result of rapid growth in Government expenditure without corresponding increase in mobilisation of resources, the Government has resorted to heavy deficit financing (i.e., the creation of new money).

This has further created the conditions of excess demand in the economy which have led to the rise in general price level. Besides, the increase in petroleum prices, many times during the last few years, the hike in administered prices of steel, cement, coal, fertilizers, increase in indirect taxes on several commodities, in increase railway fares and freights have all led to the cost-push inflation or what is also called supply-side inflation.

Now, when due to the demand pull inflation, the general price-level rises, the demand for rise in wages and deafness allowance are made by the working classes and they have to be conceded to in view of the rising cost of living. The rise in wages and dearness allowance of the workers raises the cost of production.

The increases in cost of production due to higher wages and clearness allowance also cause the aggregate supply curve to shift to the left and bring about cost-push or supply-side inflation. Thus there has been persistent rise in prices under the combined impact of demand-pull factors caused by the large budget deficits arid cost-push factors due to the hike in administrated prices of petroleum, steel, cement, coal etc., and increase In indirect tax’s on commodities such as sugar, cloth, cooking gas, soaps, cold-drink, etc.