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The Effects of Inflation

Inflation is regarded as undesirable because it produces some serious economic and social problems.


Inflation leads to an arbitrary redistribution of real income. Although a rise in the general price level produces a corresponding rise in money incomes, all prices do not rise to the same extent and different income groups will be affected in different ways. There will be some 'gainers' and some 'losers'.

The losers are those whose incomes are fixed, or relative­ly fixed, in money terms. This group will include people whose income is derived from fixed interest securities, controlled rents, or some private pension schemes. Income recipients in this category will experience a fall in their real incomes.

When incomes are directly related to prices, real income will remain relatively unchanged. The incomes of sales people, and professional groups such as architects, surveyors, and estate agents whose fees are expressed as a per­centage of the value of the work undertaken, fall into this category. A large number of wage earners also come into this group since many workers have agreements which link their money wages to the Retail Price Index.

The effects on incomes derived from profits depend largely upon the kind of inflation being experienced. During demand-pull inflation, profits tend to rise. The prices of final goods and services tend to be more flexible in an upwards direction than many factor prices, some of which are fixed on fairly long-term contracts. The margins between the two price levels tend to widen because of this time lag. When there is cost-push inflation, profits may he squeezed. Since there is no excess demand some firms may find it rather difficult to pass on the full effects of rising cost in the form of higher prices.

Wage earners generally more than hold their own when the price level is rising. In the UK and most other industrial countries wages in most years have risen faster than prices, but as already mentioned, there tends to be some redistrib­ution effect as those with superior bargaining power gain at the expense of the weaker groups.

Inflation tends to encourage borrowing and discourage lending because debtors 'gain' and creditors 'lose'. Debtors repay in monetary units which have less purchasing power than those which they borrowed. If a person borrows a sum of money for 2 years during which time inflation is running at 10 percent per annum, the same sum repayable at the end of the term will be worth about 17 percent less in real pur­chasing power than the sum of money borrowed. It is for this reason that lenders demand higher rates of interest during periods of inflation.


Demand-pull inflation is associated with buoyant trad­ing conditions and sellers' markets where the risks of trading are greatly reduced. These easy market conditions might give rise to complacency and inefficiency since the compet­itive pressures to improve both product and performance will be greatly weakened. This is not likely to be the case in a cost-push inflation where trading conditions are likely to place a premium on greater efficiency. Where firms cannot absorb some of the higher factor prices by improving pro­ductivity they may find it difficult to survive. It is possible that employers seeking to hold down costs will react to rapidly rising wage cost by devising means of economizing in their use of labour and hence raise the level of unemploy­ment.

Demand inflation, it is sometimes argued, is conductive to a faster rate of economic growth since the excess demand and favorable market conditions will stimulate investment and expansion. The falling value of money, however, may encourage spending rather than saving and so reduce the funds available for investment. It may also lead to higher interest rates as creditors demand some additional return to compensate for the falling value of money. Nevertheless rel­atively high nominal rates of interest may not be a deterrent to investment. If the nominal rate of interest is 10 percent, but the rate of inflation is 8 percent, the 'real' rate of inter­est is only 2 percent.


In economies such as the UK which are dependent upon a high level of exports and imports, inflation often leads to balance of payments difficulties. If other countries are not inflating to the same extent, home-produced goods will become more competitive in the home market. Exports will be depressed and imports will rise. If this process con­tinues it must lead to a balance of payments deficit on the current account. The problem will be a particularly difficult one where inflation is of the demand-pull type, because in addition to the price effects the excess demand at home will tend to 'draw in' more imports. These balance of payments effects apply particularly where a country is operating a fixed rate of exchange. A floating rate of exchange means that the rise in home prices does not have such an unfavorable effect on the volumes of exports and imports.


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