Economical Effects of Inflation on a Country

Economical Effects of Inflation on a country

Inflation can be described as a positive rate of growth in the general price level of goods and services. Carbaugh (2001) claimed that inflations are most probably the outcome of either an upward pressure on the buyers' side of the market (demand-pull inflation) or an upward pressure on the sellers' side of the market (cost-push inflation). More often than not, economists agree that inflation is bad and also a defect of an economy because, over time, it destroys the value of money. (Kwok Seng, 2002) In general, inflation touches on the economic behaviours that can have substantial impacts on the operation of the economy, but that of course would depends on whether the inflation is an outcome of anticipated or unanticipated inflation and the degree of inflation as well. (Case & Fair, 2004)

Redistribution of wealth and income

Samuelson & Nordhaus (2005) have said that inflation affects income and wealth unevenly across the population due to the fact that there are differences in the assets and liabilities that people hold and that redistribution occurs because many loans in the economy are stated in terms of money. Suppose you borrow RM300, 000 to buy a house and your annual fixed-interest-rate mortgage payment are RM30, 000. Suddenly a great inflation doubles all incomes. "You will need to work half as long as before to pay your mortgage payment because the inflation has increased your wealth by cutting half the real value of your mortgage debt." (Samuelson & Nordhaus, 2005: 673) With inflation the sum of money being repaid over time will buy less goods and services than at the time the loan was made, the value of money gets down gradually while the loan remain constant and that the borrower will gain at the expense of the lender. (Kwok Seng, 2002) What is more, during inflation people who have higher bargaining power would be better off as they are able to raise their income above the inflation that occurs, in turn, their real income increased and the opposite would goes to those who has low bargaining power or those on pensions plan.

The German hyperinflation in 1923 has eliminated the value of all life insurance policies and debts left in banks. The value of German mortgages in 1913 measured in U.S. dollars was about $10 billion; in late 1923 these mortgages were worth only one U.S. penny. By 1924 the inflation had almost completely redistributed the wealth of Germany. (Schenk, 1998)

The Misallocation of Resources, Uncertainty, & Lack of Investments

In addition to redistributing incomes, inflation can also harm economic efficiency by affecting the economic system - the allocation of resources and price signals. During low or no inflation, the firms who received the signal on actual changes in supply and demand would naturally channel more resources to the particular goods or services that generate better profit. However, if inflation is high where all prices in the economy rise, firms would not be able to distinguish between the rises in price caused by increased in demand (relative price rise) and the rises in overall price level as a result of inflation (absolute price rise). This in turn, price mechanism failed to undergo its function in the allocation of resources and leads to inefficiency in the economy. (Kwok Seng, 2002) Fluctuating inflation causes firms uncertain of the steps they should take. This in turn, uncertainty occurs and firms started to choose not to invest in the economy due to difficulties in predicting the outcomes of their investments: their real costs and revenues. If firms invest in new factories that later prove to be unprofitable. Firms may be discouraged from investing and the prospects for long-term economic growth are lessened. (Case and Fair, 2004)

During the US inflation where prices of house increased and people started to buy houses to avoid higher prices later, a lot of newly started-up sawmills did unwell as they came on-line when the housing market's boom in 1970 turned out to be a bust. When inflation is highly volatile, they would be less confident that they will be able to earn enough to pay off the debts, and thus may reduce investment. (Hellerstein, 1997)

The Wastage of Resources - Shoe-leather and Menu Cost

Besides that, Anderton (2000) has emphasised that economic inefficiency will as well, leads to shoe leather cost and menu cost. As the result of unstable rising prices, consumers and firms are more likely to hold less cash and more interest bearing deposits as the values of money people hold in their wallet lose its value gradually. This in turn, people tends to keep money in the bank and goes to the bank more frequently as they hold less cash in hand.. Thus, people would have to spend more time and less convenience in order to be able to frequent the bank almost everyday. This kind of sacrifice is known as the shoe-leather cost. Mankiw (2004) extends Anderton (2000) idea by putting forward that as price rises day by day or maybe even in term of hours, firms had to spend real resources adjusting their price tags. This cost of price adjustment is known as menu cost, which involve the cost of printing new menus, new price list and catalogs. Samuelson & Nordhaus (2005) even claimed that sometimes the cost are intangible, such case involves the gathering of people to make new pricing decision.

For instance, during the Yugoslavian hyperinflation in 1991-1994, firms or sellers even gave up frequently changing price tag as its is costly. In turn, they just put on a sign to indicate the multiple of the prices stated on the goods and services. Customers have to multiply the factorial with the prices on the price tags to get the actually current selling price. (Watkins)

Inflation, Negative Balance of Payment & Unemployment

Sloman (2000) claimed that when domestic inflation of a country is much higher than foreign countries, exports of that particular country would be less competitive in the international market. Increase in cost of production (wage, oil prices) during inflation would leads to increase in the price of outputs which in turn, price of domestic goods and services that are exported are much higher than prices of goods and services sold by foreign countries. As a result, countries with higher inflation would find their goods and services less demanded in the international market. Contrary, imports in the home market of economy with higher inflation