Effects of Inflation

Effects of Inflation

The effects of inflation are all pervasive. It affects all those who depend on the market for their livelihood. The effects of inflation may be favourable or unfavourable, and low or high depending on the rate of inflation. Following are the major effects of inflation:

1. Effects of Inflation on Distribution of Income

The effect of inflation on income distribution depends on how it affects the price received and price paid by different sections of the society, especially the consumers and the producers. Prices received are the same as incomes defined crudely. For example, households receive their incomes in the form of factor prices-wages and salaries, rents and royalties, dividend, interest, profits and income from self-employment. Similarly, actual prices paid represent the expenditures on consumer goods and production inputs. Inflation changes the income-distribution-pattern only when it creates a divergence between total price received and total prices paid by different sections of the society . For example, let us consider only two major forms of incomes-wage incomes and profits. When price rise is so evenly distributed that wages increase proportionately to the rise in profit incomes, the income distribution remains generally unaffected. When output prices increase faster than input prices, profits rise faster than wage incomes, which is generally the case, incomes get redistributed in favour of the profit earners—the employers. However, if inflation is predictable and consumers are able to adjust consumption pattern and wage earners can move from low-wage jobs to high-wage jobs, then the impact of inflation on income distribution is considerably mitigated.

What happens in general, however, is that product prices increase first and at a faster rate, and input prices (especially wages) increase later and at a lower rate. It is so because, there is always a time-lag between the rise in output prices and input prices. For example, prices of goods and services increase first, in general, and wages of labour after a time gap—we know that when prices of consumer goods increase, dearness allowance is paid after a time gap. This is the general case. As a result, wage incomes flow to produces of wage-goods first and at a faster rate than the reverse flow. Consequently, inflation cause redistribution of income in favour of the producers. Consequently, rich (firms) get richer and poor (labour) get poorer.

2. Effects of Inflation on Distribution of Wealth

From the view point of analysis here, let us look at wealth as accumulated assets. Assets can be classified as:

i. Price Variable Assets, and

ii. Fixed Value Assets.

i. Price Variable Assests

Price-variable assets are those whose prices change with change in the general price level. The money value of price-variable assets increases, during the period of inflation. Price-variable assets can be further classified as:

(a) physical assets including land, building, automobiles, gold, jewellery, etc., and

(b) financial assets including shares and stocks.

ii. Fixed Value Assets

 The fixed-value assets, on the other hand, are those assets whose money value remains constant even if the general price level changes. Fixed-value assets include bonds, term deposits with banks and companies. Loans and advances, etc. Like assets, there are liabilities also. Liabilities are mostly of fixed claim nature like house loans, car loans, bank loans, and mortgage of property. Let us assume, for the sake of simplicity in the analysis, that fixed value assets and fixed value liabilities cancel out.

In that case, the effect of inflation on the distribution of wealth depends on how inflation affects the net wealth (= assets – liabilities) of the different classes of wealth holders. The effect of inflation on the net wealth depends on how inflation affects the money value of the price-variable assets. If prices of all price-variable assets increase at the rate of inflation, then there will be no change in asset portfolio and no change in wealth distribution.

However, if price of price-variable assets increases at a rate higher than the rate of inflation, inflation changes the distribution of wealth. Inflation changes wealth distribution by changing the wealth accumulation ability of the different groups of wealth holders. Suppose there are only two categories of wealth holders – the high wealth and the low wealth holders. In general, high wealth holders belong to high income groups. The ability to acquire wealth depend on the ability to save and ability to save depends on the income. As a matter of the general rule, the high income groups have a higher ability to save and therefore a higher ability to acquire wealth. During the period of inflation, income of the high-income groups increases at a higher rate than that of the low-income groups. As noted above, during the period of inflation, income of the businessmen increases at a higher rate than that of the employees, and income of the business executives increases faster than that of the low-grade employees. Therefore, the higher income groups are able to save more and accumulate more wealth than the lower income groups. As a result, the wealthy people are able to acquire more and more wealth than the low wealth holders. It may thus he concluded that inflation changes wealth distribution in favour of the wealthy class of the society.

3. Effects of Inflation on Different Sections of Society

As noted above, the overall impact of inflation is unpredictable. However, inflation has certain definite and predictable effect on the income of certain sections of society. These are briefly discussed below.

i. Wage Earners

It is a common belief that wage earners are hurt by inflation. Some authors consider this belief as a myth. ‘ In fact, whether wage earners lose or gain by inflation is again a matter of labour-market conditions. In developed countries labour is, by and large, organized and labour market is competitive. According to Baumol and Blinder “the average wage typically rises more or less in step with prices.” This contradicts the ‘popular myth’ that wage earners are, in general, losers during the period of inflation.

However, the economist’s finding that inflation benefits labour can hardly be accepted as a universal phenomenon. For labour market conditions and price variations vary from country to country and from time to time. The labour markets in the less developed countries, mostly in the countries facing a large scale open and disguised unemployment, are generally divided between organized and unorganized labour markets. In India, for example, the employment share of unor­ganized sector is much larger—nearly five times bigger—than that of the organized sector. The wage in the unorganized labour market have not increased in proportion to the rate of inflation. Therefore, the labour in the unorganized sector is a net loser during the period of inflation. However, things have been found different in the organized sector. According to a study conducted by Times Bureau (May 2009), the rise in the wage rate was 5-6 percentage point higher than the labour productivity in the manufacturing sector in 2007. This might be both the cause and the effect of inflation. Thus, it may be concluded that inflation harms the labour in the unorganised sector but it benefits the labour in the organised sector.

 ii. Producers

Whether producers gain or lose due to inflation depends, at least theoretically, on the rates of increase in prices they receive (the sale price) and the prices they pay (input prices or the cost of production). In general, product prices rise first and faster than the cost of production. Therefore, profit margin increases and producers gain.

The product prices rise first due to demand-pull factors such as rise in money supply, rise in income (as was the case in India in 2007 and 2008), or supply bottlenecks. The input prices remaining the same, profit margin increases. This creates additional demand for inputs pushing the input prices up, though at different rates and with different time lags. As mentioned above, wages and salaries increase in the long run in step with the rate of inflation. However, it must be borne in mind that wages and salaries do not increase automatically and simultaneously during the period of inflation. So there is a time lag. Therefore, producers gain during inflation due to wage-lag. Besides, other input prices increase at a lower rate. Therefore, producers are the net gainers.

However, firms have to bear some additional cost, called menu cost. During the period of inflation, especially when inflation rate keeps increasing, firms are required to revise their prices, print new price lists and publicize their new prices. The cost incurred for this purpose is called menu cost. In spite of the menu cost, the firms stand to gain from inflation.

iii. Fixed income class

The people of the fixed-income category are the net losers during the period of inflation. The reason is that their income remains constant even during die period of inflation, but the prices of goods and services they consume increase. As a result, the purchasing power of their income gets eroded in proportion to the rate of inflation.

iv. Borrowers and lenders

In general, borrowers gain and lenders lose during the period of inflation. For example, suppose a person borrows Rs 5 million at 12 percent simple rate of interest for a period of five years to buy a house. Suppose also that escalation in property prices is such that property prices double every 5 years. After 5 years, the borrower would pay a total sum of Rs 8 million whereas the price of house rises to Rs 10 million. The borrower gains by Rs. 2 million. The lender loses by the same amount in the sense that had he bought the house himself, his asset value would have risen to Rs. 10 million.

v. The government

The government is a net gainer during the period of inflation. In order to analyze the government’s gain from inflation, let us consider the government as a taxing and spending unit and as a net borrower. As regards the effects of inflation on tax revenue, inflation increases revenue yields from both, the direct and indirect taxes. Consider first the direct taxes, viz., personal and corporate income taxes.

Inflation increases tax yields from personal income tax in at least three ways.

  • Inflation redistributes income generally in favour of higher income groups. This kind of income transfers enlarge the tax base for the personal income tax. As a result, the yield from the personal income tax increases.
  • Inflation increases the nominal income at the rate of inflation, real income remaining the same. As a consequence, an income which was non-taxable prior to inflation becomes taxable after inflation. This also enhances the tax base and, therefore, the tax revenue.
  • With the increase in the nominal income due to inflation, incomes taxable at lower rates becomes taxable at a higher rates. This increases the yields from personal income tax.

As regards the corporate income tax, tax-yield increases during the period of inflation on account of two factors.

  • During the period of inflation, output prices increase generally faster than the input prices. Therefore, the total profit increases. Consequently, the yield from the cor­porate income tax increases. Even if output and input prices increase at the same rate, the volume of nominal profit increases. This increases the tax yield.
  • The yield from the corporate income tax increases also due to tax laws in respect of depreciation allowance. Firm’s tax liability is determined after deducting the allowable depreciation of the plant and equipment. In determining the tax liability, depreciation is allowed on firm’s book-cost of plant and equipment, not on their (inflated) market value. The taxable profit is overstated to this extent. This enhances the government’s revenue from the corporate income tax.

As regards the revenue from indirect taxes, it depends on whether indirect taxes (customs, excise and sales tax) are imposed at fixed rate per unit of output or at ad valorem rate. If taxes are imposed at fixed rate, the rise in price does not affect the revenue. However, indirect taxes are generally imposed at ad valorem rates. The ad valorem rates enhance the revenue from the indirect taxes in direct proportion to the rate of inflation. The additional revenue accruing to the government due to inflation, tax rate remaining constant, can be called inflation tax.

4. Effect of Inflation on Economic Growth

The effect of inflation on economic growth can be examined at both theoretical and empirical levels. Theoretically, the rate of economic growth depends primarily on the rate of capital formation which depends on the rate of saving and investment. Therefore, whether inflation affects economic growth positively or negatively depends on whether it affects savings and investment positively or negatively. Most economists hold the view that there is a positive relationship between inflation and saving and investment and, therefore, inflation is conducive to economic growth.

As regards the empirical evidence of relationship between inflation and economic growth, there is no clear evidence of whether inflation helps or hinders growth. The historical records and empirical researches do not seem to have produced a clear evidence of positive relationship between inflation and economic growth, at least in the long run.

 

For more study material on Managerial Economics, visit the following links:

Managerial Economics

Effects of Inflation

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