The commonest effects of inflation on any economy are a reduction in real wages, increased cost of living, reduced savings and investment, overall slowdown in economic growth, social unrest and political instability.
But the above are not the only effects of inflation on the economy. Also, while there are many negative effects of inflation, a well-managed level of inflation can bring certain benefits to the economy.
In this tutorial, we shall discuss the major effects of inflation on both the economy and society as a whole. I promise to make these study notes as easy to understand as possible. For this reason, you will have simple, practical examples to explain each point about the effects of inflation on individual households, businesses and the government.
One more thing. Did you know that a certain level of inflation can bring positive results to the economy? Just keep reading. You will soon find out.
Are you ready to discover the effects of inflation? Let’s go get them!
Which level of inflation is not good for the economy?
According to Investopedia, a mild level of inflation is needed to engineer economic growth. That is when the rate of inflation is restricted to 2% or less. This type of inflation is known as Creeping Inflation.
So the effects of inflation we are about to look at are more related to a different type of inflation. We are looking at a situation where inflation is way above 2% and keeps rising beyond 10%.
Inflation becomes a big problem for the government and other policymakers to solve when it reaches the level of galloping inflation and hyperinflation.
The adverse effects of inflation are very much linked to the relationship that exists between the level of inflation and the value of money.
Relationship Between Inflation and the Value of Money
There is an inverse relationship between inflation and the value of money.
What this means is that as inflation increases, the value of money decreases.
In other words, as prices go up, the quantity of goods and services that a certain amount of money can buy reduces.
The reverse is also true. That is if inflation begins to fall, the same amount of money can now afford a bigger quantity of goods than previously – all things being equal.
How Inflation Affects the Functions of Money
A high rate of inflation undermines the ability of money to perform its functions in the economy. Let’s take a quick look at each one of these.
Money As A Medium of Exchange
It becomes difficult for both buyers and sellers to accept money when its value is decreasing very fast during a period of galloping inflation or hyperinflation.
This is why some producers in countries that are experiencing very high rates of inflation quote their prices in a stronger external currency like the US dollar when prices keep skyrocketing.
Money As A Unit of Account
Money is like the measuring rod that we use to determine the value of goods and services in our daily transactions.
It is helpful because it is a standard yardstick and a common denominator that applies to all goods and services.
Money, thus, makes all economic transactions fair to all parties involved without any misunderstanding.
But the moment inflation sets in, the value of money and public confidence in it may be so undermined that some people may begin to use other means for determining the value of their products.
This will create confusion and distortions in the economy.
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Money As A Store of Value
One of the most important functions of money is that it is a convenient means of storing wealth of any kind. People find it more convenient to save their excess wealth in banks as money than to store commodities such as maize, tomato, cattle and yam for the same purpose.
During a period of hyperinflation, however, it no longer makes economic sense for individuals, firms and even the government to store their wealth as money. This is because the value of money cannot be relied upon any longer.
Money As A Standard for Deferred Payment
In a period of relative economic stability, it is easy for lenders to give money to borrowers who are supposed to pay back with an agreed level of interest in the future.
But as soon as a high rate of inflation sets in, lenders do not see the need to lend money knowing very well that there could be a drastic fall in the value of the same amount with any added interest payment.
Now that you know the negative effects of inflation on the functions of money, shall we now turn our attention to another aspect of the topic?
During inflation, there are winners and there are losers too.
Who gains most during inflation?
Borrowers or debtors and variable income earners are among the groups of people who may gain the most during inflation.
Debtors
For debtors, the reason is that by the time they are supposed to pay back borrowed money, the value would have decreased so much that it is easier to pay back their loans with interest.
Variable Income Earners
Workers who are paid negotiable hourly wages and commissions and small business people who can quickly adjust prices based on current costs of production or have large amounts of old stocks to sell may also gain marginally during inflation.
Who are the losers during inflation?
People who are the losers in a period of hyperinflation are lenders or creditors and other fixed-income earners.
Creditors
As we saw under the effects of inflation on money’s function as a standard for deferred payment, any future loan repayment that creditors receive tends to be significantly lower in real terms than what they gave out as loans.
Fixed Income Earners
Fixed-income earners also suffer during a period of very high inflation. Examples are retirees, salaried workers and landlords.
The Adverse Effects of Inflation
Inflation can have several effects on an economy and society. While a few of these effects of inflation may be good for households, firms and the government, a very high rate of inflation does a great deal of harm to the economy.
We shall now identify the major negative effects of inflation on the economy and society at large.
1. Reduction in Real Wages and Purchasing Power
Inflation can reduce real wages. Workers may receive nominal wage increases but these may not keep up with rising prices.
The result is a fall in the purchasing power of consumers. The same amount of money can only buy a fraction of the same goods it could buy before.
In other words, inflation makes it more expensive to buy goods and services.
2. Increased Income Inequality
Inflation can increase income inequality in the sense that low-income households may be less able to cope with rising prices than higher-income households.
3. Increased Cost of Living
As prices continue to increase at a rapid rate, the general cost of living also increases. This places much burden on consumers, forcing their standard of living to fall.
Inflation can reduce the quality of life for individuals and households because they need to cut back on spending or make difficult choices about what goods and services to purchase.
4. Reduced Savings
Over time, inflation tends to cause a reduction in the level of savings.
As inflation undermines the critical function of money as a store of value, it gets harder for people to save for retirement or other long-term goals.
5. Lower Investment Returns
Another adverse effect of a high rate of inflation is that it as the value of money continues to fall significantly, it can cause a reduction in the real returns on investments in savings accounts, bonds, and other investments.
6. Economic Uncertainty and Instability
Inflation can create uncertainty and instability in the economy. The volatile economic atmosphere, coupled with fluctuations in the value of the national currency makes it harder for businesses and individuals to plan for the future.
This undermines productivity and economic growth.
7. Reduction in International Competitiveness
Compared to other economies, inflation can make a country’s goods and services more expensive. Inflation, therefore, makes it tougher for the country to compete in international markets.
A possible decrease in the demand for the country’s exports, for example, can worsen its balance of payment position.
8. Wage-Price Spiral
The possibility of a wage-price spiral is among the numerous negative effects of inflation. A wage-price spiral is a situation where workers demand higher wages to keep up with rising prices, leading to further inflation.
9. Reduced Economic Growth
A wage-price spiral is a vicious cycle that has dire social and political ramifications.
A high inflation rate can slow down economic growth by reducing investment and discouraging entrepreneurship.
10. Negative Impact on Fixed-Income Earners
Inflation tends to be particularly harmful to fixed-income earners, such as retirees, who rely on a fixed income that may not keep up with rising prices.
11. Social Unrest and Political Instability
Inflation can lead to social unrest, particularly among low-income households and unemployed youth that are most affected by rising prices.
Additionally, inflation can increase political pressure on governments to take action to address rising prices, which can lead to unplanned policy changes that may have unintended consequences.
High levels of inflation are noted to have caused the collapse of some governments across the globe.
12. Misallocation of Resources
Inflation can lead to distorted resource allocation. This happens because profit-conscious businesses and individuals focus on investing in areas that will bring short-term gains rather than directing such factors of production into more sustainable long-term investments.
13. Reduced Consumer Confidence
Among the major effects of inflation is a reduction in consumer confidence.
Inflation can reduce consumer confidence, as people become more cautious about spending and investing. As aggregate demand falls, production levels also fall. The obvious effect is a slowdown in economic growth.
14. Reduced Investor Confidence and Capital Flight
It is not only consumer confidence that suffers during an inflationary period. Investors also tend to lose their faith in the economy’s ability to protect their investments and reward them for their risk-taking efforts.
Thus, high inflation rates can reduce business investment, as businesses may be less willing to invest in an economy that is experiencing high inflation.
Those who have already made investments may begin to look elsewhere.
15. Increased Borrowing Costs
Inflation can increase borrowing costs, making it more expensive for businesses and individuals to borrow money. This not only leads to a fall in investments but also causes the general standard of living to fall.
16. Reduction in Real Interest Rates for Savings
Inflation can decrease real interest rates. This makes saving and investing less attractive to those who can. Instead, increases the incentive to spend now rather than later.
17. Reduced Foreign Investment
High inflation rates can reduce foreign investment in a country, as investors may be less willing to invest in an economy that is experiencing high inflation.
18. Currency Depreciation
Inflation, which may be the result of a rapid depreciation in the value of the local currency, often leads to further depreciation.
Though this may make exports more competitive it also increases the cost of imports. The result could be an unfavourable balance of payments.
19. Inflation Undermines Economic Efficiency
Inflation can reduce economic efficiency, as businesses and individuals spend more time and resources managing the risks of inflation rather than focusing on productive activities.
Positive Effects of Inflation
Even though inflation is generally considered to be an unwelcome development in the economy, it has certain potential benefits.
Let’s have the possible positive effects of inflation.
20. Stimulation of Economic Growth
Inflation can encourage economic growth. For example, rising prices can motivate businesses to increase production and investment to keep up with rising demand.
Inflation May Encourage Spending
In the face of persistent price increases, consumers tend to spend money now rather than later. The goal is to avoid the future purchase of goods and services that may become more expensive over time.
This can lead to increased demand, increased economic activity and job creation.
21. Reduced Debt Burden
Inflation can reduce the burden of debt on borrowers, as the value of debts decreases in real terms. This can make it easier for individuals and businesses to repay their debts.
22. Redistribution of Income
Inflation can redistribute wealth from rich creditors to debtors, as the value of debts decreases in real terms. This may cause a narrowing of the income gap between those in the low-income and high-income brackets.
23. Increased Employment
Inflation can increase employment by encouraging businesses to hire more workers to keep up with the rising demand for goods and services.
24. Encouraged Investment
Inflation can encourage investment among those who can afford it. This is because when the inflation rate is very high, it is more expensive to hold surplus cash than to invest it.
The result could be increased investment in stocks, bonds, and other assets.
25. Improved Balance of Payments
Inflation has the potential to improve a country’s international trade position. The depreciation of the local currency will likely make the country’s exports relatively cheaper and more competitive in foreign markets.
This can help to increase demand for the country’s exports especially where the demand for such export commodities is price elastic.
26. Increased Nominal Incomes
Inflation can increase nominal incomes leading to higher consumer spending and overall economic activity. This can be particularly beneficial for workers in industries where wages are indexed to inflation.
27. Encouraged Innovation
Economic hardship and the desire to profit more from increasing prices can motivate entrepreneurial individuals and the government to become more innovative.
For example, inflation can encourage innovation by creating incentives for businesses to invest in new products and technologies that can help to reduce costs and improve efficiency.
Conclusion
One key point worth noting is that inflation is not entirely a bad thing. It is the level of inflation and the rate at which it increases that matters. This is why the effects of inflation, though generally negative, may also be positive in certain cases.
As we have observed, a mild rate of inflation can potentially bring certain positive effects on the economy.
A very high rate of inflation, on the other hand, is what must be constantly combated since it can have a very negative effect on overall economic growth and the standard of living.
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