Inflation and its consequences

High rates of Inflation are harmful to an economy. Inflation redistributes income and wealth. Uncertainty about the value
of money makes business planning more difficult. Constantly changing prices impose.

Inflation

Inflation is the name given to an increase in price levels generally. It is also manifest in the decline in the purchasing power of money.
Historically, there have been very few periods when inflation has not been present. We discuss below why high rates of inflation are considered to be harmful. However, it is important to remember that deflation (falling prices) is normally associated with low rates of growth and even recession. It would seem that a healthy economy may require some inflation. Certainly, if an economy is to grow, the money supply must expand, and the presence of a low level of inflation will ensure that growth is not hampered by a shortage of liquid funds.

Why is inflation a problem?

An economic policy objective which now has a central place in the policy approaches of the governments of many developed countries is that of stable prices. Why is a high rate of price inflation harmful and undesirable?

1. Redistribution of income and health:

Inflation leads to a redistribution of income and wealth in ways which may be undesirable. Redistribution of wealth might take place from account payable to accounts receivable.

This is because debts lose ‘real’ value with inflation. For example, if you owed $1,000 and prices then doubled, you would still owe $1,000, but the real value of your debt would have been halved. In general, in times of inflation those with economic power tend to gain at the expense of the weak, particularly those on fixed incomes.

2. Balance of payments effects:

If a country has higher rate of inflation than its major trading partners, its export will become relatively expensive and imports relatively cheap. As a result, the balance of trade will suffer, affecting employment in exporting industries and in industries producing import-substitutes. Eventually, the exchange rate will be affected.

3. Uncertainty of the value of money and prices:

If the rate of inflation is imperfectly anticipated, no one has certain knowledge of the true rate of inflation. As a result, no one has certain knowledge of the true value of money or of the real meaning of prices. If the rate of inflation becomes excessive, and there is ‘hyperinflation’ this problem becomes so exaggerated that money becomes worthless, so that people are unwilling to use it and are forced to resort to barter. In less extreme circumstances, the results are less dramatic, but the same problem exists. As prices convey less information, the process of resource allocation is less efficient and rational decision-making is almost impossible.

4. Resource costs of changing prices:

A fourth reason to aim for stable prices is the resource cost of frequently changing prices. In times of high inflation substantial labor time is spent on planning and implementing price changes. Customers may also have to spend more time making price comparisons if they seek to buy from the lowest cost source.

5. Economic growth and investment:

It is sometimes claimed that inflation is harmful to a country’s economic growth and level of investment. A study by Robert Barro (bank of England quarterly bulletin, May 1995) examined whether the evidence available supports this view. Barro found from data covering over 100 countries from 1960-1990 that, on average, an increase in inflation of 10 percentage points per year reduced the growth rate of real GDP per capita by 0.2 to 0.3 percentage points per year, and lowered the ratio of investment to GDP by 0.4 to 0.6 percentage points. Although the adverse influence of inflation on economic growth and investment appears small, this could affect a country’s standard of living fairly significantly over the long term.

By: AQSA RIAZ

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