What are possible effects of inflation?

The effects of inflation can be classified at three levels: international, insular and personal. Let’s examine each in turn.

In the international field, inflation rates have to be identical between all trading partners if trading flows are to remain undisturbed. In a world where most governments are making efforts to reduce their domestic rates of inflation, the rate of inflation in a country has come to have particular international significance. The community which lives by trading in finance regards its government’s record with regard to inflation rate as an indication of its ability to control the domestic economy. When inflation rates exceed the tolerances allowed for by a government, selling of that country’s currency often takes place. The currency consequently depreciates. The effect of this is to make inflation even worse, especially if the country concerned is a major importer of raw materials and semi-finished goods. Inflation gets worse because, when a currency floats downwards or is devalued, import prices rise. When disparate rates of inflation exist between nations, cooperation in the monetary field becomes extremely difficult.

According to insular Aspects of Inflation, consumers soon become accustomed to inflation. The habits of saving for consumption are soon forgotten. As far as consumers are concerned the immediate purchase of goods, especially consumer durables, is the rational course - they have developed inflationary expectations. This means that they expect the present inflation to continue, and perhaps, even to get worse. In such a situation the obvious line of action is to buy now before the price rises. Of course, that only fires inflation. The other aspect is that when inflation persists it becomes increasingly difficult for businessmen and investors to calculate real rates of return on capital expenditures.

According to personal Aspects of Inflation, Inflation influences the behaviour of individuals within an economy. Those who depend upon fixed sources of income find that the real value of their income flow is diminished. But there are others who can take advantage of inflation. In times of inflation fixed debt tends to diminish in significance. Hence those who have mortgages find that their incomes rise but the repayments do not and the real cost of borrowing diminishes. Vast numbers thus have at least some vested interest in continued inflation. Yet another way in which inflation affects the behaviour of individuals is that it encourages them to find inflation-proof outlets for accumulated funds. Those commodities in fixed, or almost fixed, supply tend to increase in price ahead of the general rate. Such ‘hedges against inflation’ enable a person to escape the worst rigours of an unfavourable economic climate.

    WHAT ARE EXPLANATIONS FOR INFLATION?

Inflation is a period of rising prices. The measurement of inflation depends upon the general price level and it is perfectly possible for the general price level to rise while specific prices fall.

The general price level must therefore be a form of average. The normal method of calculation is by the use of price index. The best known price index, and the one usually chosen to indicate the level of inflation, is the Index of Retail Prices.

       During the years when monetarism was out of fashion, changes in the level of aggregate demand were used to explain why inflation occurred. Called demand inflation it takes place when supply cannot respond and leads to a rise in prices instead of to extra output. Cost inflation assumes that the collective upwards ’’push’’ of costs is sufficient to raise the general level of prices even though there has been no noticeable increase in the level of aggregate demand. In order to grasp the idea of cost inflation it is necessary to distinguish between costs in total and costs per unit of output. For example, wage rates - the rates paid to each employee - can rise and yet the wage element in each unit of output can still fall, provided that output per man rises. In such a situation any extra payments are provided for by extra sales. Then inflation is not fueled, since more output is forthcoming and costs per unit should not rise. However, in markets for labour resources the granting of one group often leads to demands that such deals be extended to other groups even though no extra productivity is forthcoming. And that is a source of cost inflation. Yet another explanation for inflation, bottleneck inflation, is a close relative of both demand and cost inflation. Bottleneck inflation assumes rising costs and rising prices long before all resources are fully employed. The basis for this assumption is that specific shortages occur in some areas -bottleneck areas - of the economy where demand is unusually heavy.

 

 

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