The Effects of Inflation
In the world of economics, the phenomenon of inflation is described as a rise in the general level of prices and goods in an economy over a period of time (Wyplosz and Burda, 1997). When the general level of price rises, each unit of a given currency buys less products or services; because of this consequence, inflation is also a decline in the real value of the aforementioned currency. This causes a loss of purchasing power in the medium of exchange, which is also the monetary unit of accounting in an economy (Central Bank of Iceland, 2008). Inflation is something all economies must endure, and inflation causes a variety of effects on those economies, both positive and negative.
Inflation can be prompted from a decline in the economy and lobbying by borrowers for an increase in money production (The politics of inflation, 2008). It is generally agreed upon by economists that high rates of inflation and hyperinflation, a severe rise in prices, is directly caused by the influx of newly printed money (Barro and Grilli, 1994, p. 139). Because of the adverse causes that inflation have upon an economy, most economists prefer a low steady rate of inflation (Hammel, 2007). Low inflation has the ability to reduce the severe impact of inflation’s effects upon the economy, preventing economic recessions and enabling the labor market to adjust better when the economy takes a downturn (Inflation, 2008).
The effects of inflation upon an economy can be broken down into positive and negative effects. While no differential is completely black and white, this division provides very clear differences of inflation’s effects on the economy. Many economists have laid bare their views on the ideas and effects of inflation, and this provides us with an idea of how the effects can be broken down for consideration.
Many people who do not have a background in economics, or a knowledge of the way economics works, would like to believe that there are no positive effects to be gained from inflation. However, these views are shadowed by personal experience and not a wide view of how inflation affects the economy as a whole. Examples of positive effects that inflation has upon the economy are it’s ability to help labor market adjustments, reduce debt, leaving room to maneuver within the economy, and the Tobin effect.
Using the Keynesian economic theory, which is the theory that money is transparent to the real forces in an economy and that the pressure of these forces is the cause of inflation, it can be believed that nominal wages adjust downward slowly. This leads to a high level of unemployment within the labor market due to prolonged disequilibrium. Because inflation lowers the real value of wages, if nominal wages are kept constant, it is argued that inflation is a benefit to the economy because it allows for the labor market to achieve equilibrium more quickly. According to the Keynesian economic theory, equilibrium within the labor market is key to a healthy economy.
The effect that inflation has upon debt is a great benefit to the borrower. Borrowers who have a fixed rate of interest will see a reduction in the real interest rate as the inflation rate increases. The real interest on a loan is figured by the nominal rate minus the rate of inflation, or R = n – i. For example, if the stated interest of a loan is 7%, and the inflation rate is 4%, the real interest that the borrower is paying for the loan is 3%. The higher the inflation rate, the more benefit that the borrower receives. If the same loan with a fixed rate of 7% were in an economy where the inflation rises to 15%, then the borrower would have a real interest rate of –8%. This highly benefits the borrower, but it also detriments the lender. Many money lenders, including most banks, make adjustments for this type of inflation effect, by including an inflation premium in the costs of lending the money, or by having a variable interest rate instead of a fixed rate. In essence, the benefit of debt relief for borrowers, which is a positive effect, is also a negative effect for banks and other lenders.
To control the money supply, banks use the primary tools of the ability to set the rate of discount, the rate at which the banks borrow from a central bank, and controlling the open market operations, the central bank’s interventions into the bond market. This is used to control the rate of nominal interest within the economy. If the rate of inflation is low, or reaches zero or below, then banks cannot cut the nominal rate when the economy is in need of stimulation, which is called a liquidity trap. Keeping the inflation rate at a moderate level ensures that banks avoid this liquidity trap and are able to lower the nominal interest rate if necessary. In this manner, the effect of inflation allows for economic stability.
The best argument that can be offered that inflation is a positive economic consequence is the Tobin effect. James Tobin, a noble prize winning economist, has argued that moderate levels of inflation lead to an influx of investment within the economy. Because inflation lowers the real value of currency, it lowers the return that investors receive on monetary assets. Due to this fact, investors favor turning monetary assets into real assets, physical capital for example. In order for investors to avoid the negative effect of inflation upon the value of currency, and therefore investors’ monetary assets, investors choose to invest in physical capital, which would not lose value due to inflation. This allows for economic stimulation in the areas of physical capital.
Unfortunately, inflation tends to have a more negative effect on the economy than a positive one. While it is able to be helpful in the ways mentioned above, the negative factors are larger and have a greater impact upon the economy, especially factors such as hyperinflation and cost-push inflation.
Cost-push inflation is a wage spiral that causes further inflationary expectations. Rising inflation prompts many employees to see higher wages, and often demand higher wages from current employers so that they can continue with their current quality of life by keeping up with the increase in the price of goods and services. The rise of wages then in turn helps fuel inflation. Collective bargaining causes wages to be set as a factor of price expectation, which will be higher when inflation takes and upward trend. This can cause a wage spiral (Encyclopedia Britannica)
Hoarding is also a common negative effect of inflation. Consumers will purchase goods that will continue to be a store of wealth in order to rid themselves of excess cash before it becomes lower in value. This creates a shortage of the goods being purchased because they are being bought in larger quantities in ordered to be hoarded until inflation takes a downward turn.
Hyperinflation is when inflation becomes totally out of control in the upward direction. Hyperinflation wreaks havoc upon the normal workings of an economy. It severely hurts the economy’s ability to supply goods and services to consumers, and causes high unemployment levels (Inflation inconveniences, 2008).
Inflation negatively affects allocative efficiency as well. A change in the supply or demand of a specific good will cause a change in price for that good. This signals buyers and sellers to re-allocate resources because of the change in market conditions. However, when a price is continually changing because of the effects of inflation, it is difficult to for agents to correctly re-allocate resources and this creates a loss of efficiency.
There is also a negative effect to opportunity cost, known as “shoe leather cost”. What this means is that it costs people a greater opportunity cost to hold a cash balance, and often shows most people holding money in interest bearing accounts instead. However, cash is still needed for purchases, so that means that people have to make more trips to the bank to withdraw funds. The name “shoe leather cost” is derived from people metaphorically “wearing out the shoe leather” with all of the extra trips. In our economy today, debit cards are helping to counteract this opportunity cost.
There is also a negative inflation effect upon the many businesses that use brochures or menus, which contain pricing. Inflation causes these businesses to have to change the prices of goods or services, which in turn means that the businesses must print new menus or brochures reflecting the price change. When inflation is in a constant flux, this can create quite a large additional cost for businesses because of the continual need to reprint brochures and menus.
The most damaging effect of inflation is when inflation upsets the business cycle. This can lead to artificially low interest rates, which when added to the increase of monetary supply associated with inflation causes reckless, speculative borrowing. Reckless borrowing leads to large amounts of bad investments, which have to be liquidated when they become unsustainable (Thorsten).
Inflation can have both positive and negative effects upon an economy. Governments use inflation to both stimulate and decelerate an economy (The politics of inflation, 2008) New money is printed so that the government can spend the money within the economy, which allows for businesses to have an influx of said money and they can then spend the money in the economy as well. However, though this is thought to be a way to cause great economic activity, which in turn pulls an economy out of a recession (The politics of inflation, 2008), this is not always the case. The money added to the economy will produce positive activity at first, but then the monetary value is lessened. The extra money causes a loss of value, so the situation eventually is reduced to its original circumstances and often worse circumstances.
Economists have developed ways to combat the effects of inflation. The primary tool that is used to control inflation and its effects is monetary policy. Other tools that are used include fixed exchange rates, the gold standard, and cost of living allowance. These tools are used to keep the effects of inflation at a minimum and to help prevent the severe negative effects such as hyperinflation and the offset of the business cycle.
The monetary policy tasks central banks with keeping the federal funds lending rate at a low, reasonable rate. Normally, this target rate is roughly two to three percent per annum, and includes a low inflation rate of roughly two to six percent per annum. Higher interest rates and a slower influx of money helps the central banks to combat the effects of inflation.
Fixed exchange rates help to combat the effect inflation has on monetary value. A country’s currency is tied to another country’s currency or to currency of another kind. This helps combat inflation by stabilizing the value of currency.
Another form of monetary stabilization is the gold standard. This is when monetary notes, like paper money, are equal to a certain prefixed amount of gold. When the gold standard is used, the currency itself is of no value, but is accepted as currency because it is back by its equivalent gold value.
Cost of living allowance is an important form of combating the effects of inflation. When cost of living allowance is used, wages are directly tied to inflation. When inflation increases enough, a cost of living increase is made to wages. A specific cost of living index is used, and it usual on par with the consumer price index. This allows for employees’ wages to counteract the negative effect of inflation lowering demand for products, because employees can still afford products and services.
The deep impact of inflation upon an economy is seen directly in the effects of inflation upon the business cycle, and the effects of inflation upon borrowing and lending. The effects of inflation being both positive and negative require that inflation be kept in a delicate balance. Because inflation is required to prevent liquidity traps, and helps to stimulate the economy in certain ways, inflation cannot be eradicated completely.
Due to the fact that inflation is needed, many ways of controlling inflation have been implemented to help keep the delicate balance of inflation and its effects. This is accomplished through the cooperation of the central banks, and those banks use of monetary policy. The gold standard helps to combat the effect of monetary destabilization, which is a large consequence of inflation. The cost of living allowance also helps in the combating of inflation and its negative effects.
In closing, it seems that inflation is a necessary evil within an economy. Due to its few positive effects, it cannot be ignored. To keep the peace within the system of our economy, a delicate balance of inflation is kept through careful watch and the use of combative strategies.
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