The Impact of Inflation on the Economy and Business - Essay Example

When Inflation Rises, Everyone Loses Inflation is defined as the increase in the cost of goods and services measured against a standard set in the past. Inflation, thought to have a bad effect on an economy, is sometimes called the consumers worst friend. It lowers the purchasing power of consumers. Theoretically, if a product costs $1.00 and the inflation rate is 10%, that product will cost $1.10 in a year. People on fixed incomes are often hurt the most by high inflation. It lowers the value of their savings, retirement funds, and social security check. Wage earners suffer because cost of living raises are based on data accumulated in the previous year and the worker never catches up to the current inflationary position. Inflation impacts corporations by raising the prices on their raw materials and lowering their profits. It is also an unpredictable environment to operate in. Businesses are reluctant to make investments during periods of volatile inflation. It should be said, that business does not suffer from a high inflation rate, because higher costs are passed on to the consumer. It is the uncertainty that they suffer from. The inability to plan is what makes inflation the enemy of business. A countrys budget is also impacted by rising inflation. Countries suffer from a tax rate that is based on pre-inflationary periods that are less than the current value. Countries are also faced with budget concerns of purchasing products at inflated prices based on the lower tax revenues from a previous period. Companies have trouble competing in the world market due to rising costs. It also causes exports to go down as prices go up resulting in a trading deficit. It should also be noted that inflation might at times work in favor of the consumer. If a consumer borrows money and pays it back with interest, inflation may actually reduce the amount of the loan. Since they will be paying it back in future dollars, if inflation is greater than the interest rates, the value paid back will be less than the dollar borrowed. This sometimes can be seen as real estate prices rise in response to inflation. While this may seem to benefit the consumer, in the long run this tends to increase consumer debt and may have a negative effect when the housing bubble bursts as we have seen recently in selected real estate markets across the country. There are always cases around the globe where inflation is rising faster than in other more stable areas. Super high inflation is usually brought about by the political or social structure of a country in turmoil. Wars can bring about high inflation, usually because of a lack of goods. If there is a product shortage, those few goods will be sold to the highest bidder, and that will be the few people willing and able to pay the highest price. It also may also be due to a country printing excess paper money to cover the cost of a war. A guideline for high inflation is often termed "double-digit" inflation. The US has seen periods of double-digit inflation in the past. In 1980, the US experienced an inflation rate of 13.58% ("Inflation Historical"). During that year, oil prices has spiked to over $100 a barrel from a previous price of less than $50. The cost in energy drove up prices across the board. When oil prices were brought back under control, the inflation rate fell with them. During the period of 1990-present, the inflation rate in the United States has hovered around 3% or a little below ("Inflation Historical"). There are other examples of exceedingly high inflation around the world. One recent example that is often studied is Ecuador. They experienced an inflation rate of greater than 95% in 2000 ("Background Note: Ecuador"). This was caused by a weak economy largely due to corruption and mismanagement. They had also incurred a large debt from El Nino and the resulting storm damage in 1998. At the time they had a floating currency that was not tied to an international standard. When the president was ousted in Jan. 2000, it caused panic and uncertainty. This resulted in a 75% spike in a one-month period. The new government restructured the debt, privatized state owned industries, and tied the currency to the US dollar. The following years saw lower rates and it had dropped to 1.9% in 2004 ("Background Note: Ecuador"). The war and the resulting economic hardships in the former Yugoslavia resulted in inflation rates in the period 1971-91 of almost 70 percent. There we periods when the inflation rate remained above a 50 percent per month in 1989 (Hanke). According to experts, Slobodan Milosevic triggered the hyperinflation by giving a $1.8 billion in illegal loans to Serbian owned business (Hanke). A lack of confidence in government fueled inflation in Yugoslavia just as it had in Ecuador. It was only brought under control when the war ended and a new government was installed. Though the UAE and Dubai have not seen these rates of inflation, it has been on the rise in recent years. It was 2.8% in 2002 and is estimated to hit 20% in 2006. That was up from 10.5% in 2005 ("United Arab Emirates"). The rate was 3.2% and 4.6% in 2003-2004. The UAEs inflation rate has been fueled by soaring rents and to a lesser degree rising food costs. Though Dubai is a producer of oil, its inflation rate is still impacted by the rising cost of energy. They need large amounts of oil in the industries and processing that it takes to produce consumer goods. Government rent controls and an increase in housing supply is expected to ease the pressure and return the rate to less than 6% in 2007 ("IMF Sees UAE Inflation Dropping"). When is inflation too high for the consumer? According to the Federal Reserve Board, "Policymakers usually equate low inflation to annual increases of 1 to 2 percent in a broad index of consumer prices, excluding food and energy, a rate that the current Fed chairman, Ben Bernanke, once dubbed the optimal long-run inflation rate" (Anderson). As has been seen, the United States has been living with a 3% rate during the past 15 years. This has been a time of great expansion and also of recession. The stock market has seen historic highs and has had a period of a significant bear market. The inflation rate neither affected the economy greatly and the economy was not influenced by the inflation rate. This is probably due to the Federal Reserves ability to closely monitor the money supply and the interest rates. The economy and business can do the most to control inflation. The recent history of stable inflation rates has been attributed to business and globalization. According to Samuelson, " [...] The economy has become vastly more competitive since the 1970s. Its harder for companies to raise prices, because they face imports or low-cost domestic rivals". He further sates that, "Productivity has also improved since the 1970s, helping companies absorb some cost increases without raising their prices ("productivity" means "efficiency" and is measured by output per hour worked)". Greater production and more competition results in a health consumer economy. Governments can control the inflation rate by closely controlling the money supply. By limiting the amount of money in circulation, it will limit inflation. Countries who print paper money excessively create high inflation rates. It can also be somewhat controlled by maintaining stable interest rates. Governments can have very little positive effect attempting to control prices. Wage and price controls only serve to limit production, which is counter-productive towards limiting inflation. Another thing the government can do to control inflation is stimulate production. By increasing and controlling production, the government can limit price pressures and inflation. This has been done with some success in agricultural products and has helped to stabilize the cost of foods. By offering subsidies to prop up prices, it helps to reduce volatile market fluctuations, which lead to product shortages. This insures a steady supply of goods and tends to keep the inflation rate at a predictable level. Inflation reduces the spending power of the consumer and erodes the value of their savings. Left unchecked, it can devastate an economy. Though usually caused by government upheaval, short-term spikes in the prices of necessary goods such as energy can cause it. Business can probably have the greatest effect on inflation by increasing competition and production. When working with a responsible government that regulates interest rates and the money supply, the inflation rate can remain stable. Works Cited Anderson, Richard G. "Inflations Economic Cost: How Large? How Certain?" The Regional Economist (2006). 2 Dec. 2006 . "Background Note: Ecuador." Bureau of Western Hemisphere Affairs. Nov. 2006. US State Department. 2 Dec. 2006 . Hanke, Steve H. "New Currency Boards Come to the Balkans." Beyond Transition . 2001. The World Bank Group. 2 Dec. 2006 . "IMF Sees UAE Inflation Dropping." Middle East Times 9 Oct. 2006. 2 Dec. 2006 . "Inflation Historical." InflationData. 2004. Capital Professional Services. 5 Dec. 2006 . "United Arab Emirates." The World Factbook. 30 Nov. 2006. Central Intelligence Agency. 2 Dec. 2006 . Samuelson, Robet J. "Inflation: Why Its Not That 70s Show." Washington Post 26 Oct. 2005. 5 Dec. 2006 . Read More