Effects of Inflation

A.
Effects/Costs of Inflation
Though increase in price level benefit some people in the society, it has harmful effects on all others.
If prices of all goods and services increase in the same rate and all can anticipate the increase in price
level, no one would be hurt from inflation if it does not affect the economy's output and its rate of
change over time. However, prices of all goods and services do not rise at the same rate as such
inflation provides gains to some and hurts others. The following are the main costs society has to bear
from inflation:
Redistributive Effect:
Inflation increases inequality in the economy by making the poor poorer and the rich richer.
 Since wage rate remains constant for a certain period of time, the wage earners generally lose
and the profit earners generally benefit during inflation.
 Resource owner benefit whereas wage/salary/interest earners suffer.
 Creditors lose and debtors benefit.
 Shareholders benefit and bond holders lose.
 Fixed income groups lose while variable income groups gain.
Tax Effect
People implicitly bear tax due to inflation. With inflation nominal income increases in the economy
and individuals are pulled up in higher income groups and higher tax brackets. On the other hand with
inflation, people cannot buy their planned quantities and it can be taken a kind of tax on goods and
services.
Inefficiency Cost:
With inflation, producers are sometimes compelled to switch between production technologies which
creates a waste of resources invested. For example if due to a heavy rise in the price of capital goods,
if a producer switches from capital intensive technique to labor intensive technique, the investment on
capital goods is wasted which creates inefficiency in production.
Social Cost of Inflation:
With inflation, the nominal interest rate in the economy rises which reduces the demand for real
balance kept for speculative purpose. This reduces the benefits in terms of convenience and security
provided by money that no other alternative assets can provide. This loss is called social cost of
inflation.
Shoe Leather Cost
As inflation takes place in the economy, interest rate increases instantaneously as such people tend to
keep more cash in banks. On the other hand, they need more money for transaction purpose to maintain
consumption as before. Thus, they have to devote more time for travelling to bank and come back
which demands a lot of time and inconvenience. It is called shoe leather cost of inflation.
Menu Cost:
If prices of goods and services change frequently, the sellers have to change their menu frequently
which requires a wastage of resources. It is called menu cost of inflation.
1
Inconvenience Cost:
When inflation takes place in the economy, the value of money goes down continuously. So money
can not work as a measuring rod which creates inconvenience.
Uncertainty Cost:
If inflation is rapid, people do not accept money and they tend to converge to barter system.
Second Cost of Inflation:
As inflation takes place in the economy, it goes on increasing and invites another inflation. This is
called second cost of inflation.
Other effects:
 Social effects: widening gap between haves and have-nots creates conflict in the economy.
 Moral Effects: encourages black marketing, adulteration and other malpractices.
 Political effects: general discontentment of the public, corruption, revolution, etc.
 Affects the BOP adversely.
 May lead to the collapse of the monetary system.
B. Measures to Control Inflation

The following methods can be used to controlling inflation:
1. Monetary Policy:
If the inflation is the result of rapid increase in AD, monetary policy can be tightened by one
or more of the following means:
 Increasing the Cash reserve ratio (CRR)
 Increasing the bank rate and other policy rates to increase nominal interest rate in the
economy.
 Mopping off liquidity from the market by using open market operations.
 Tightening the consumer credit from banks and financial institutions.
 Credit rationing: setting the limits on the credit that the banks can lend.
2. Fiscal Policy:
 Reducing unproductive government expenditure.
 Increasing the tax base and or tax rates.
 Postponing the repayment of public debt.
 Compulsory saving schemes.
3. Increase in the Level of Output if the economy is not fully employed.
4. Encouragement for Saving L: (Tax exempt on savings etc)
5. Overvaluation of Domestic Currency: If currency is over valued, the inflation from the
changes in exchange rates is neutralized to some extent. But this method is vary much rare.
6. Indexing: This method is used to minimize the harmful effects of inflation on fixed income
earner groups. Here, wages and salaries are adjusted according the changes in price level.
2
C. Causes of Inflation
Demand Side Factors
 Increase in money supply by the monetary authority
 Increase in govt. expenditure (Development and war)
 Increase in private expenditure (C and I)
 Reduction in Tax rate
 Decrease in savings
 Increase in export
 Increase in population
 Paying the old debt to the public
 Earning black money
Supply side
 Natural calamities
 Scarcity of factors of production
 Hoarding of goods
 Trade union activities
 War
 International causes
 Law of diminishing returns
 Wag push inflation
 Profit push inflation
 Import push inflation
 Tax push inflation
 Depletion of resources

Effects of Inflation

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Effects of Inflation

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A.

B. Measures to Control Inflation

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