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EFFECTS/CONSEQUENCES OF INFLATION – Class notes

Depends on:
1. The rate at which it is rising
- Very high rate would be very damaging (hyperinflation)
- Problems with hyperinflation [refer to pg3]
-
2. Whether the rate is accelerating or stable
- Refer to pg4 ‘accelerating vs. stable inflation’

3. Whether the rate is the one which has been expected

- Refer to pg4 ‘anticipated vs. unanticipated inflation’

4. How the rate compares with that in other countries.

- Refer to [pg2- Pt3] External effect → ‘instability of exchange rate and effect on
international trade’

EFFECTS OF INFLATION
Effects of inflation are not evenly distributed. Some people are better off while others are
worse off.
1. Inflation will result in CHANGES IN INCOME REDISTRIBUTION PATTERN

a) Groups that GAIN b) Groups that LOSE

-Those with VARIABLE incomes - Those with FIXED incomes

eg.1 Businessmen – the businessmen buy eg. Pensioners

materials at old prices, rented property at old - wage or salaried worker,
rate, pay workers at old rate. - landlords with fixed rental income,
-there is a time lag before employees demand - debenture holders (shares/bonds with fixed
for higher wages, banks call for higher interest rates of return)
etc. - creditor/ money lender who is repaid in
-in the short run at least, he benefits because inflated dollars ie. money which has less
his costs lag behind price rise. Therefore high purchasing power than that of the money he
profits are made. lent out initially.
Eg.2 Debtor (borrower) – gain because the real
value of his debt is reduced by the price rise.
-when he borrowed the money earlier, it had
greater purchasing power. In fact now, he is
repaying less than what he owed in terms of its
real value.
Eg.3 Equity holders – equities are shares with
variable rates of return. During inflation, profits
of businessmen increase. Higher profits will
lead to greater dividend on equity.
Eg.4 Farmer -his costs lag behind price rise
Eg.5 Salesmen on commission – commissions
are variable.
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2. Effects on SAVINGS
- Individual savings will FALL, because the real value of savings is ERODED by
inflation (especially if the real rate of interest is lower than the rate of inflation)
- Corporate savings will INCREASE because businessmen gain in the short run as
his COSTS LAG BEHIND PRICE RISE.

3. Effects on BALANCE OF PAYMENTS (BOP) – External effect

- If domestic rate of inflation is greater than overseas/world rate of inflation,
domestic prices would be higher.
- Export prices would be higher than import prices
- Result : receipts from exports < payment for imports, leading to a worsening in
Balance of Payments which may lead to a fall in the exchange rate.
- In the long run, people may lose confidence in the currency.

4. Inflation may result in CHANGES IN RESOURCE ALLOCATION

PATTERNS
- Increased demand will lead to increase in prices as consumers are willing to pay.
- Resources will be allocated to the production of goods and services for which
there is an increased demand.
- So, there will be some wastage in the process of reallocation to adjust.

5. Inflation may result in INDUSTRIAL UNREST

- Trade unions become more militant/powerful in their wage demands
- Strikes may take place to maintain real wages which have been eroded by
inflation
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6. Inflation may result in SHOE-LEATHER COSTS

- In times of rising prices, consumers and firms will be less clear on what is a
reasonable price than when prices are stable.
- This will lead to more ‘shopping around’, spending more time transferring money
from one type of account to another. This is a time cost.

7. Inflation may result in MENU COSTS

- If there is inflation, price labels have to be changed.
- Menu costs refer to the physical resources expanded in making price adjustments.
- Restaurants have to alter their menus to reflect increased prices.
- Shops have to change their price labels
- Firms have to calculate their new price lists
- Even more costly are changes to vending machines, pay telephones and parking
meters.

8. UNCERTAINTY
- especially prolonged inflation
- if household spending falls, firms will reduce output, Investment will fall,
unemployment will increase leading to a fall in economic activity.

A very high rate of inflation (20%) would be very damaging and is called hyperinflation.
When this occurs people will lose confidence in money and may even go back to barter. eg.
Germany between 1913 and 1923. Argentina 2002.

Problems with People with fixed

HYPERINFLATION incomes will feel a fall in
their real income level.

Instability in
Government, thus
political instability Companies lose purchasing
power because their money have
been lying idle and not earning
interest.
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Inflation makes it more difficult to assess what is happening to the price of goods and
services. A rise in the price of a good may not mean that it has become more expensive
relative to other goods. It may mean that it is cheaper if it has risen less than inflation.

Firms can plan for the future Firms will also benefit if prices rise by
without worrying about inflation, more than costs since this will mean
thus more competitive. that profits will increase.

Advantages of a low, stable rate of inflation

(eg. 2%)

Stimulates consumption because real Helps firms which need to reduce cost. This is
interest rates may be low or even negative done as inflation rises, the cost of wages does
as the nominal rate changes in line with not rise, and thus the real wages of the workers
inflation. Thus debt burden falls. go down.

Accelerating vs. Stable inflation

Accelerating or fluctuating inflation causes uncertainty in firms and consumers. Consumers may
want to stock up goods before the price rises even more while firms will have to deal with the
higher wage demands of workers and thus increase their product prices. This discourages firms
from undertaking investment. Stable inflation makes it easier to predict future inflation and
hence, easier to plan and protect people from the harmful effects of fluctuating and accelerating
inflation.

Anticipated vs. unanticipated inflation

Anticipated inflation – the rise in general price level is close to the expected. This gives confidence to
firms and investors. Can take measures to avoid the harmful effects ( eg. maintaining real prices,
income and taxation).

Unanticipated inflation – when inflation is not expected or is higher than expected. This can bring
with it a number of problems. As people and firms have been caught unaware, they are likely to be
uncertain about future inflation. This can result in a fall in consumption and investment.

Fiscal Drag – when higher nominal pay will drag income into higher tax bands and workers’ real
disposable income will fall. A redistribution of income occurs. (eg. Borrowers will gain, lenders will
lose because nominal interest rates rise more slowly than than inflation rate)