Effects or consequences of Inflation

Inflation is such an evil that we can neither fully support nor go against. It has both good and bad faces i.e. it has both positive and negative effects on the economy and life of people. Actually, calling it an evil will also not be considered as a good idea. People may curse the rise in prices but they also love it because they are also engaged in some type of production or service providing to earn money and they definitely want to increase the price of services they provide. In this article, we will discuss about all the consequences of increase or decrease in the inflation rates. Before you read this article, you should know the proper meaning of Inflation.

Inflation is general increase in price level of goods & services over some period of time(generally,it is discussed in years) and the percentage change in this price level is called Inflation rate.

1) Effects of Inflation on Economy:

Relation between Inflation and economic development does not follow any linear pattern. We cannot directly say if it brings economic growth or decline. We will talk about most obvious relation put forward by empirical and logical theories.
Firmly speaking, a controlled inflation, preferably not more than 6% is essential for economic growth. But a very large inflation rate (like more than 10%) tends to have a negative effect. You may curse the increase in prices but it is a need for economic development. If there is no price change (0% inflation rate) or decrease in prices (deflation or negative inflation rate), it may hit the economy severely and pave the way to recession.
If inflation is positive and at reasonable levels (decided by government and central bank for their country), it helps to reduce unemployment, increase living standards and bring economic growth. The target level of Inflation varies for different countries according to their economic situation. Developed nations like USA try to keep it as low as 2% to 4% while developing nations or partially developed ones can target a little above. The graph can help you to understand the relation in between two better.
effects of inflation on economic growth of nation

2) Decrease in Purchasing Power of Currency:

Decrease in purchasing power is just an obvious point here because this is the very point, that we oftenly use to define the Inflation. When the prices of service, product or product basket increase, you would get lesser quantity of that entity in same amount of money. This time (after increase in prices), same amount of money is letting you to buy lesser quantities, we can say that Inflation erodes the purchasing power of currency.
Fairly talking, definition of Inflation explained with the point above is used all over the internet but it does not tell you the root meaning of Inflation. The definition – “Inflation is general increase in price levels of product Basket, goods and services over a given period of time” gives you an equitable meaning of Inflation and we cannot call it wrong at all. But real sense of Inflation is always explained with the Money supply and changes in Money circulating in the economy is called inflation. Money supply and prices follow each other and that is why we use the marked definition most of the times because it is easier to understand that way.

3) Effect of Inflation on Currency or Foreign Exchange Rate:

High Inflation Rates have negative effect on the currency of country at international level. It is not like that inflation rate completely controls the exchange rates but; it does, to some extent. Infect, I would say that change in exchange rates have more effect on inflation as compared in other direction. Decreasing exchange rates lead to increase in Inflation but vice-versa effects are also true to their limits. This will make more sense to you when you will learn about Purchasing power parity (PPP). Purchasing power parity means equalizing the purchasing power of currency with respect to the cost of living and adjusted with inflations to make the comparisons between two countries without any conversions or calculators.
Exchange rates adjusted according to their local PPP are always considered more valid at international scale. As you know that Purchasing Power decrease with inflation or increase in inflation. This leads to weakening effect on the currency of our country.
NOTE: Sometimes, countries intentionally try to reduce the Power of their currency for benefits in international trade. Even India have gone through Devaluation of currency 2 times. If you want to learn more about Devaluation of currency, visit the article.

4) Effects of Inflation on Unemployment:

You might find it strange but consequences of Inflation are positive in this case. It is an empirical theory that increasing inflation brings the unemployment numbers down. This concept was introduced by Mr. AW Phillips in 1958 with help of Phillips curve. He studied the correlation between Wage Inflation and Unemployment in UK between 1861 – 1957 and came to this conclusion. Theory he used to explain this is that Inflation comes with economic growth which surely increases the employment opportunities and reduce Unemployment. Vice-Versa is also true i.e. if Unemployment rate goes down, Inflation rate increases. But to reduce unemployment, if government and central Bank (RBI in India) stop controlling Inflation, it may lead to Hyperinflation, which is also not preferable either.

To have a better understanding about this theory and correlation between Unemployment and Inflation rate, you should have a look on – Relation between Inflation and Unemployment

We cannot say that this theory is 100% true or reliable. In 1973 – 1975, USA faced a condition of both High Inflation rate and High Unemployment rate due to expenses of Vietnam war, fall in manufacturing jobs and Economic sanctions (Embargo) by oil-rich nations against USA in retaliation due to its support for Israel. Such a condition is referred as Stagflation. But stagflation is not like a regularly occurring event. As a bottom-line, we can say that Phillips curve works well in short term i.e. Inflation and Unemployment have negative correlation but in longer term, we cannot be totally reliable on it. In longer term, economy tends to go back to its natural unemployment rate (this is minimum resulting rate from voluntary or real economic forces like structure of labor force) and it adjust to any Inflation rate (this was first supposed by the
Monetarist economists A monetarist is an economist who holds the strong belief that money supply—including physical currency, deposits, and credit—is the primary factor affecting demand in an economy. Consequently, the economy's performance—its growth or contraction—can be regulated by changes in the money supply.
in 1960s).

5) Effects of Inflation on People of Society:

Changes in price are inevitable and have effects on everyone. Inflation have different sequel on different people of the society. Some will feel positive about it and some will curse it:
  • Fixed Income Earning People:

    If someone is earning a fixed amount of money each month, quarter or a year would be definitely against Inflation. Just give it a thought, a person with fixed income has roughly fixed expenditure. If price increase but the income does not, it is definitely going to affect his/her savings (if any) , or will have to cutdown some of the expenses.
    This is one of the major reasons behind people preferring government jobs in India as their increases by some rate each year which makes them secure against Inflation. This is not always true in case of private sector jobs. Even if wages are increased, it is not always increased upto the mark of inflation. In such cases, even after little increase in income, real income decreases. Labourers are one of worst hit people in this case.
  • Creditors and Debtors:

    Creditors – Creditor is a person or organization that provides credit or loan to another party.
    Debtors are the second party that receives loan or credit from the debtor at some rate of interest for a given period of time.
    If someone takes loan from Creditor, let say for 5 years with a fixed interest rate for all 5 years; he will have to pay a fixed extra amount (money for interest) each year other than the base money take as loan. But as we know that real value of money is reducing each year due to inflation. You have to pay a predefined fixed amount of money each month or year but the real value of that money will not be same in coming 5 years, yet you have to pay only that. Here we can say that Inflation acts as a helping hand for the debtors.
    Some creditors thus write in agreement to increase the interest each year to adjust its value with inflation over the time while some keep it fixed but with little increase in interest rate after studying the market statistics.
  • Producers:

    Producers will generally get benefits in business because they will get higher prices from the sales of their products. Though, it is not necessary. It varies with businesses too. For carrying out their production, they also need to buy raw materials, Pay Bills which are also liable to get increased their cost due to inflation. Nothing can be controlled by only one factor in production and manufacturing business. But generally speaking, producers are at benefits during inflation as the price of end products are still in their control. But it can be a difficulty for the workers working under them as workers at lower level in private sector are not generally given proper treatment and increase in pay is also not guaranteed. That is why labour, employment and wage laws are required, but they are not fully developed in many countries and India is also among them.
    Due to increasing prices and demand, producers or other businessman can also start the activity of Hoarding or Black-marketing which will immediately reduce the supplies and prices will rise at even more higher rates. This is what we call as Artificial Inflation.
  • Investors:

    Increasing prices create uncertainties and these uncertainties due to fluctuating prices motivates Speculators to participate more. Investor, without any doubt are at benefit from increase in prices of their assets. It is a little setback for people investing in areas where returns are fixed, for example: Bonds. Their profits are fixed and relatively more secure but due to inflation, their real profits are little lesser.
    Relation between stock market and inflation cannot be discussed in a single paragraph. If you want, you may visit the link provided:

    Effects of Inflation on stock-market

6) Effects of Inflation on Business and Trade:

As we know the positive inflation upto a certain level is linked with growing economy. Therefore, Inflation tends to have an overall positive effect on Internal trade and Business in the Country.
But as the prices of products increase in India, other countries will also have to import them at their new increased prices which raises the possibility of some downfall in demand. You may have the question that Indian people will also get those products at higher prices, then why do we talk about negative possibilities regarding export and not about decrease of demand in Indian markets? Well, when we talk about nationwide inflation, it is not only the prices of products that increase but earnings, wages, profits and living standard of Indians also increase making them compatible with the Price Inflation of country. But for foreign countries, their inflation rate, economic cycle are following different path from ours. Their changes in currency, living standards are at different pace. And we are not saying that exports are definitely going to fall. Other countries also face inflation. There are many countries in world and all have same concerns to face.
In our domestic market also, if price of some commodity increases at higher rate than general development in inflation, wages etc., its demand may decrease. We have seen this in India many times regarding onions and pulse prices.

7) Raises cost of Borrowing:

This is not a direct effect from inflation but it is a consequence of one of the measures taken by government and central Bank (RBI in India) to control Inflation. Please don’t confuse it with the debtors and creditors case that we discussed above. This is about the interest rate at which you get loan and that case describes effect on that Interest rate after sometime.

8) Effect of Inflation on Government Finances:

Inflation also have an impact on government decisions, tax revenues and debt payments. Inflation makes it easier for the government to pay its debt. Due to inflation, both wages and price of product Baskets of Consumer Price Index, WPI etc. increase. Government collects tax from both of them i.e. as income tax and VAT. There are many other taxes in case of products at different levels from Factory to retail market. If income raises by 5%, government tax collection through this should also increase by about 5%. So, inflation automatically increases tax revenue for the government. As government issues bonds at fixed price, the real amount that government have to pay back in future is reduced due to inflation as we discussed the case of debtors and creditors above. Let say government issued Bonds of Rs. 1000 and have to pay it next year. Inflation rate in this period is 5%. So, the value of those 1000 Rupees paid will be reduced to Rs. 950. Moreover, as income of government also increases by inflation due to increased tax revenue, the share of money they have to pay as debt will be counted as small proportion than earlier periods when revenue was comparatively less. More about Inflation and Government Debt Payment

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