Effects of Inflation on the Economy

There are multi-dimensional effects of inflation on an economy. This can be seen both at the macro and the micro levels. It redistributes income, destabilises employment, tax, saving and investment policies and it may result in recession.

• Inflation erodes purchasing power. An overall rise in prices over time reduces the purchasing power of consumers. This is because the number of goods and services that can be bought by the same unit of currency decreases as inflation increases.
• Inflation redistributes wealth from creditors to debtors. The lenders suffer and borrowers benefit from inflation because inflation allows borrowers to pay lenders back with money of lesser value than borrowed.
• Inflation results in higher interest rates. This is because the central bank tries to control inflation by increasing the interest rates. As the interest rates increase, borrowing money becomes expensive.
• Investment in the economy is boosted by inflation because higher inflation indicates higher demand suggesting expansion in production level by entrepreneurs. Also higher inflation results in lower costs of loans.
• Inflation feeds on itself when high and leads to a wage-price spiral. When inflation starts increasing above a certain level, the expectations of future inflation also rise. In this scenario, workers demand higher wages and employers offset their expenditure by increasing the prices of goods and services.
• In the short term, higher inflation results in an increase in the rate of savings provided by banks. But in the long run, higher inflation depletes the savings rate in an economy.
• With increase in inflation the currency of the nation depreciates because the buying power of the currency decreases. Foreign goods and services become more attractive to consumers and businesses as they are cheaper. This causes an increase in the currency supply in the forex markets and results in depreciation of the currency.
• Inflation leads to a drop in unemployment. But in the long run, higher inflation leads to a rise in unemployment. For example, during the 1960s in the USA unemployment dropped from 5.5% to 3.5% and inflation increased from 1.7% to 5.5%. But by the beginning of the 1980s the USA faced recession and inflation rates also increased. If the vicious cycle of inflation and unemployment continues, it can also result in recession. If the market is not ready for a hike in interest rates, it can result in lower economic growth. When this happens for one quarter, it is called contraction. But if this happens for two quarters in a row, then this indicates the start of recession.
• In the case of a developed economy, inflation makes trade balance favourable. For developing economies, however, inflation is unfavourable for the balance of trade due to their composition of foreign trade. The benefit to export which inflation brings into a developing economy is lower than the loss the economy incurs due to its imports. The imports become costlier due to inflation.
• Inflation makes taxpayers suffer while paying their direct and indirect taxes. Indirect taxes are imposed ad valorem (on value). Thereby increased price of goods increases indirect taxes. Direct tax burden of taxpayers also increases with increase in the gross income of taxpayers.

Effects of Inflation on the Economy: Inflation is the sustained rise in prices of goods and services over time. This leads to the erosion of purchasing power. Purchasing power is the value of a currency expressed in terms of the number of goods and services that can be bought by one unit of the currency.

During periods of rising prices, uneven inflation acts like a hidden tax, hitting certain groups disproportionately. This loss of buying power, particularly for those already struggling, is the most concerning consequence of inflation.

In this article, we will read about Inflation and mainly the effects of inflation on the economy. We will also discuss the types and causes of inflation.