Effects of inflation - Term Paper Example

Effects of inflation Introduction Inflation is the persistent increase in the general price level. It is a situation where the demand for goods and services exceeds its supply in the economy. Inflation has many effects on both the economy and the standards of living of the citizens of a country. There is the school of thought that argues that maintaining a low stable rate of inflation is the best way to achieve consistently high levels of GDP and low levels of unemployment. However, too low levels of inflation can lead to instability due to the zero lower bound on the interest rates. Inflation can either be due to cost-push factors or from demand-pull factors. In the latter there is a high amount of money in circulation such that the purchasing power is so high that the aggregate supply can’t match the aggregate demand. In the former inflation is mainly due to increases in the costs of production thus transferring that cost to the pricing of the products. An increase in oil prices will lead to cost push inflation. The effects of inflation touch on almost all aspects of the economy and the remedy of inflation which mainly comes from the government through the central bank are the main issues that this paper aims to cover. Inflation has a direct effect on investment, it causes distortions in the economy, a lot of money is spent on buying the goods due to the increase in the prices, this, discourages savings because the money is worth more in the present than in the future. The reduction in savings leads to the amount of funds available for investments. The reduction in investments level will lead to a reduction in economic growth levels which depend on the level of investments. Inflation makes it hard for firms to plan for the amount of output to produce since the firms cannot forecast the demand for their product at the higher prices they will have to charge to cover costs. High inflation causes speculation on prices and interest rates which in turn increases the risk among potential trade partners, discouraging trade. Inflation reduces the value of depositor’s savings and as well reduces the value of bank loans. In the long run, the company’s revenue and earnings should increase at the same pace as inflation. But it could also reduce the confidence of investors by reducing confidence in investments that take a long time to mature. When there is a high rate of inflation a firm may look as if it is doing well when inflation is the reason behind the growth (Wildermuth, 2012). The effect of inflation on investment occurs directly and indirectly. People are not ready to enter into contracts when inflation cannot be predicted making relative prices uncertain. This reluctance to enter into contracts will affect economic growth. High inflation leads to financial repression as governments take action to protect certain sectors of the economy. Inflation is particularly detrimental to retirees whose pensions and financial investments have to be adjusted for inflation. Pension payments are now indexed to inflation in order to reduce the effects of inflation Inflation can lead to a poor performance in the stock markets. In times of high inflation, if the firms cannot pass on the extra cost to the consumers they will most likely end up making losses. This will reduce the viability of their stocks and lead to the investors who had invested in the firms' stocks will suffer financial setback as the company makes losses. It leads to the changes in the preferred assets held by the wealthy individuals in a country. In the initial stages the three would be a preference for intangible assets so as to make a killing from the interest rates but as inflation increases there is capital flight from the stock markets by foreign and domestic investors and who instead invest their wealth in tangible assets whose value is not likely to be eroded swiftly by the inflationary tendencies. Inflation leads to a reduction in the balance of payments. When the domestic price level rises faster than it is rising internationally, there will be more imports than exports since the value of imports will be lower to the volatility of the domestic currency in response to the inflationary measures. The exchange rate will depreciate due to a reduction in purchasing power of the domestic currency and also due to a negative balance of payments. Capital outflows may also be a likely phenomenon that contributes to the depreciation. This is due to the investors who are pulling out of the volatile markets (Bootle, 2011). Inflation affects the borrowers from the financial institutions. If an individual wants to take a loan or a mortgage, the financial will want to insure themselves from the adverse effects of inflation that will reduce the value of money lent. They will charge a high interest rate to ensure that they realize the full value of their money. The effects of high and volatile inflation is that economic decision making becomes more risky, costs are higher and the choices are more limited. Inflation will lead to high wage demands. An increase in the price level, will lead to higher wage demands. This is because to maintain the status quo of the standard of living you need an additional amount of funds due to inflation, this leads to a process known as wage price spiral. At the level of inflation increases the trade unions continue to agitate for higher pay for their members to cushion them from the inflationary trends. Inflation will lead to arbitrary redistribution of income. Inflation will tend to hurt more the laborers and those in jobs with poor bargaining power, people with no trade union protection. This group of people will actually feel the real value of their pay drop. This is at the expense of the more superior jobs that are protected by trade unions. This will lead to widening of the gap between the rich and the poor in the society. Inflation will lead to unemployment. In the medium term when the firms start to make losses, they will find a way to stay afloat by reducing costs. They will do this by reducing labor costs which will mean laying-off of some workers. This increases the unemployment rate in these places. There will be a general increase in the crime rates if inflation persists. With limited funds and high prices of commodities there is likelihood of theft in a bid to make ends meet. This is mainly due to them being unemployed and a reduction in the purchasing power. A crime which is a social vice is made worse by in availability of employment opportunities in the harsh economic conditions. From the above effects one thing is clear that inflation in the medium term and long term will affect growth and development. If companies make losses or there is reduced spending by the households. The economic outlook of such a country will start to decline unless there are measures taken to arrest the situation The society mitigates against inflation through an array of measures. Households may move their savings into accounts offering higher interest rates or into other assets where the earnings outstrip price inflation. They may choose to invest in tangible, fixed assets whose value is not likely to be affected much by the inflation. Some households may consider some of their members doing several jobs on a shift basis, such that a person can be doing up to three shifts of up to six hours each. This is a deliberate move to maximize on the amount of income that can be possibly earned within his or her ability. Taking up more jobs aims at cushioning them from inflation. There is also a change in lifestyle that comes to inflation, Households may relocate to states or neighborhoods that are not that much expensive to live in, where they can live within their means under the inflationary conditions. This may be a temporary change until the inflationary tendencies are checked. However the actions of the households alone cannot remedy inflationary tendencies. The government through the central bank has to implement the policy in order to check inflation. The central Bank can use the bank rate which is the rate at which the central bank lends to other banks. When the central bank raises the bank rate, the other banks raise their interest rates making credit from banks not only expensive but also undesirable. This reduces the amount of money lent by the bank which reduces the amount of money in circulation and reduces the effect of demand pull inflation. The central bank can increase the cash reserve ratio, this is the amount of money that the commercial banks are allowed to hold as a ratio of their deposits. Increasing the reserve ratio will ensure the bank has a lower amount of money for forward landing which will mean a reduced amount of money lent. This reduces the amount of money in circulation. The central bank may float bonds and bills in the financial markets through open market operations (Bootle, 2011). This will act in part as a source of funds to the government but it will also wipe off some money from circulation thus reducing the amount of inflation. CONCLUSION Sustained growth can have damaging effects on the long-run growth in the economy. Increases in the inflationary trends will lead to lower real returns on money and all other related assets. Lower returns will particularly hurt the credit market. Inflation reduces the amount of money available for forward lending to fund capital investments. Capital flight attributable to the pulling out of investors from the domestic to safer markets overseas leads to a volatile exchange rate. This coupled up with a deficit in the balance of payments leads to a poor economic outlook. The lack of growth in the economy will lead to intertwine effects such as the rising of the level unemployment. The high unemployment level is brought about by the need for firms take care of high production costs that hurt their earnings. High levels of unemployment lead to a higher crime levels due to the high numbers of people struggling to make ends meet. All these negative effects are in effect interdependent, one consequence leads to another. Inflation affects sections of the population differently. The very low income earners with no trade union protection will be hardest hit while their high earning counterparts will be better off. The higher income groups can reallocate resources in order to mitigate against inflation but the low income groups don’t have the resources to allocate. The inflation rate can be checked by the government through the monetary policy instruments of the central bank. These measures which include the cash reserve ratio, the central bank rate and open market operations help to reduce the amount of money in circulation. When the central bank uses the open market operations it spurs interest of investors and also plays the critical role of removing excess liquidity. The reduction in the amount of money in circulation reduces the purchasing power and thus keeps inflation under control. In conclusion inflation is harmful to the growth of economy, with negative effects but it can be controlled through the intervention of the government. References Bootle, R. (2011). The Trouble With Markets: Saving Capitalism from Itself. London: Nicholas Brealey Publishing. Wildermuth, D. (2012). Wise Money: Using the Endowment Investment Approach to Minimize Volatility and Increase Control. New York: McGraw-Hill. Read More