EFFECTS OF INFLATION

• Inflation : It is defined as “an increase in the amount of currency in circulation,

resulting in a relatively sharp and sudden fall in its value and a rise in price;

• When money is generated at a faster rate than the growth in goods and services, it
is subjected to the old economic law that the more there is of something, the
cheaper it becomes.

• Inflation is a general increase in price level. Equivalently, inflation results in a

decline over time in the purchasing power of a unit of money.

• The wholesale price index, producer price index and consumer price index
measure inflation rates.
Causes of Inflation

More money being poured into the economy than the economy is worth

The volume of gold mined

Increases in producer’s cost that are passed along to customers, sometimes with
disproportionate escalations that push prices up, called cost push inflation.
 Excessive spending power of consumers, sometimes obtained at expense of savings,
that pulls prices up, called demand- pull inflation.
 Impact of international forces on prices and markets, most notably the escalation of
energy prices.

 Unresponsive prices that seldom decline, regardless of market conditions, because

wages set by union contracts and prices set.

 Inflation psychology that leads consumer to “buy ahead” often on easily obtained
credit, in the belief that prices will inevitably inflate and loans can be repaid in cheaper
rupees.
Consequences of Inflation:

i) Standard of living declines, people on fixed incomes suffer, wage earners are
afflicted by tax increases when their inflated income push them into higher tax
brackets.

ii) Confidence in the economy declines with a resulting increase in petty crime,
political instability for incumbents, greater unemployment and spreading discontent

iii) Business decisions are distorted by efforts to cope with inflation partially brought
on by lower volume and higher taxes and the ability of business to compete in foreign
markets declines.
Consequence depend on degree of inflation

1) When inflation is mild - Annual price increases of 2% to 4%

- The economy prospers,
-The condition is temporary because employers are
tempted to seek larger profits and unions commensurately bargain for higher wages

2) When inflation is moderate – Annual price increases of 5% to 9%

- people start purchasing more because they would
rather have goods than money that is declining in value
- Increased demand pulls prices still higher
3) When inflation is severe – Annual rate reaches 10% or more
- People on fixed incomes are hurt badly
- Only debtors benefit by being able to repay debts with
rupees less valuable than those that were borrowed

4) When hyperinflation is reached- it is dangerous, rapid, uncontrolled inflation that

destroys a nation’s economy

-Here money becomes essentially value less, as the Government prints it excessively
to pay expenses
- Citizens go to a barter economy in which goods and services are exchanged without
using currency
CONTROL OF INFLATION

The remedies attempted are –

 Price and wage controls

 Contraction of the money supply
 Credit restrictions
 Reduction in demand by raising taxes
 Increase demand by reducing taxes
 Enlarged supply of goods through greater productivity stimulated by
Investment incentives
 Wage price guidelines backed by political persuasion

 Also adopting a tight money policy that reduces the money supply by such
actions as raising revenue requirements for banks to limit their lending
capacity and increasing banks discounts rate, causing them to raise interest
rates on customers loan

 Adjusting fiscal policy spending and taxing programs and impositions of

wages and price control
Strategies to Combat Inflation’s Effects

1. Spend money on long-term investments.

Home improvement projects, capital expenditures for a business

2. Invest in commodities

Commodities, like oil, have an inherent worth that is resilient to inflation

3. Invest in gold and precious metals

4. Invest in real estate

5. Consider TIPS (Treasury Inflation Protected Securities)

6. Stick with equities

7. Consider dividend-paying stocks

8. Save More
Measuring inflation:

Inflation is difficult to measure because-

 Prices of goods do not increase or decrease by the same amount, nor do they change
at the same time

 Geographical differences in prices changeable buying habits of customers

 Consumer Price Index (CPI) - A measure of price changes in consumer goods and
services such as gasoline, food, clothing and automobiles. The CPI measures price
change from the perspective of the purchaser

 Producer Price Indexes (PPI) - A family of indexes that measure the average change
over time in selling prices by domestic producers of goods and services. PPIs measure
price change from the perspective of the seller

 Wholesale Price index(WPI) – Measures inflation at the wholesale level for both
consumer and industrial goods, but not for services
Constant or Real rupee

- Constant rupees is an adjusted value of currency used to compare rupee values from
one time period to another

- Due to inflation, the purchasing power of the rupee changes over time, so in order to
compare rupee values from one year to another, they need to be converted from nominal
(current) rupee values to constant rupee values, also known as real rupee

- The process of converting from nominal to real values is known as inflation

adjustment.
• - Constant rupees in any future year N can be inflated to current rupees by using the
expression

• Current rupees = (constant rupees) (1+f)N

•
• where f = Avg. Inflation rate
• OR

• Current rupees = (constant rupees) (F/P, f, N)

• Market interest rate = if = (1+i)(1+f) - 1

EX 1 A company is planning to start an employee welfare fund. It needs Rs. 50,00,000 during the
first year and it increases by Rs. 5,00,000 every year thereafter up to the end of the 5th year.
The above figures are in terms of todays rupee value. The annual average rate of inflation is
6% for the next five years. The interest rate is 18%, compounded annually. Find the single
deposit which will provide the required series of fund towards employees welfare scheme
after taking the inflation rate into account
• Solution
• Fund requirement during the first year = Rs. 50,00,000
• Annual increase in the fund requirement = Rs. 5,00,000
• Annual inflation rate = 6%
• Interest rate = 18%
• The computation of the present worth of the annual fund requirements is summarized in
Table

The value of the single deposit to be made now to receive the specified series
for the next five years is Rs. 2,16,05,704.
• After-Tax Actual Cash flow Comparisons:

-Tax effects are significant because of deductions allowed for depreciation and loan interest
is not responsive to inflation

-Depreciation is based strictly on purchase price of an asset, not on its inflation elevated
replacement price

-And interest payments on loan are set by contract in actual rupees that are not subject
inflation

- Inflation is differential rather than uniform

- Prices for goods and services do not change proportionately over time
- Escalation rates are observed for medical care, college tuitions and appliances and
electronic equipment
 Lease / Buy decisions

• Leasing is a method of financing an asset through payments over an agreed period rather
than actually purchasing the asset
• If an asset has high-investment cost and low utilization rate, then it can be considered
for lease or buy decision

• Leasing is more attractive than purchasing because of the following reasons:-

-Use of asset’s services, if a firm lacks cash or the borrowing capacity to purchase the asset

-Less effect on future borrowing capacity than debt financing

-Imposition of fewer financial restrictions than accompany a loan for purchase of a comparable
asset

-Possible reductions in the risk of obsolescence and rise in ownership costs due to inflation

-Tax advantages under certain condition

• Whether to Lease or Buy?

• The decision to lease or buy an asset involves financial, accounting and tax considerations
and a thorough economic comparison should be made before the decision is made

• Tax point of view, lease is treated as an annual expense directly deductible from income
where as purchase is an investment subject to multiyear depreciation

• The lease alternative includes the following elements:

• Cash flow(lease) = Revenues – operating expenses – lease cost – (tax rate)( revenues –
expenses – lease cost)

• The alternatives can be evaluated according to their PW, EAW or incremental IRR.
• Types of leases

• A lease is a contact between the owner of an asset, called a lessor and a lesse, who makes
periodical payments for the right to use the asset

• LEVERAGED LEASE – In this, there will be a lender who furnishes capital to the lessor to
purchase the asset, the lease is said to be leveraged

• OPERATING LEASE –is a contract wherein Lessor, permits the the Lesse, to use of an asset for
a particular period which is shorter than the economic life of the asset without any transfer
of ownership rights
e.g. Temporary use of computers, vehicles, furnitures etc.
• FINANCIAL LEASE – A commitment by both parties to specified charges for the use of an
asset for a definite period is a financial lease.
• e.g. Real estate, rail road cars, airplanes, construction equipment

• SALE AND LEASE BACK – In this , it is possible for a firm to sell an asset it already owns and
lease it back from the buyer
• - This arrangement allows a firm to obtain cash and still have the use of its asset