Consequences of Inflation

What is the correct level of inflation?

The correct level of inflation depends on a number of factors. For most industrialised economies, whose average real growth rate is 2% a year, the target rate of inflation is around 2%. Most developed economies target inflation around this level to help achieve real GDP growth of 2% a year. This target is set to promote a low and stable rate of inflation. The reason why governments do not aim for 0% inflation is that this would require low rates of economic growth to achieve and more importantly, risks the economy experiencing deflation. Deflation, as we will discuss below, can lead to a number of problems and risks very low economic growth. As such, governments tend to target a 2% inflation rate to promote low inflation and moreover stable prices (or stable price growth), both of which promote a stable economic environment for firms and households.

For rapidly growing economies, the rate of inflation may be higher as their growth rate is also higher. This does not pose a problem for an economy so long as their growth rate is greater than the inflation rate as they are achieving increases in real GDP. However, as we will discuss below, there are consequences to having a high rate of inflation.

Consequences of a High Inflation Rates

Inflation reduces purchasing power and lowers Real Incomes

Inflation is the sustained increase in the average price levels of an economy. As such, if the rate of inflation is higher, the purchasing power (what you can buy with a particular income) will decrease. Income received from factor payments buys less as the inflation rate increases. For example, imagine a household has a monthly income of $800 and a monthly shopping basket of goods costs a household $400. After purchasing the goods, a household would be left with $400 to spend on other goods and services. If the economy was experiencing high inflation of 10%, that same basket of goods would now cost $440, leaving the household $360 to spend elsewhere. As a result of the high inflation, the household in this case can purchase less with the same income. In this example, unless incomes rise 10% or more, the household is worse off as their real income is decreasing due to inflation. Therefore, inflation erodes the purchasing power of households if wage growth is not increasing in line with inflation

Uncertainty

Higher levels of inflation causes more uncertainty for economic decision makers.

For Firms

Without being able to predict future price changes firms may become more cautious to plan future investments due to the uncertainty the high rates of inflation will have on their costs and revenues. This lower investment may lead to lower levels of economic growth.

For Savers

Savers will be worse off if the rate of interest they gain from saving is less than the rate of inflation, as their real value of their savings decreases. As such this may cause fewer people to save and instead they may be incentivised to spend instead to avoid future increases in prices. This increased spending can also lead to higher inflation in the future.

For Economic Growth and Resource Allocation

Lower levels of investment by firms and lower levels of savings can both affect the levels of economic growth. High Inflation domestically can also cause a countries export competitiveness to decrease, as goods are more expensive to relative to other countries. As a result, exports (X) may decrease and imports (M) may increase, as people switch to importing goods from countries with lower rates of inflation (meaning goods are priced lower), leading to an increase in leakages to the circular flow of income and resulting in lower economic growth for the country experiencing inflation.

Redistribution Effects of Inflation

Inflation can redistribute incomes between different groups in society. That is, when an economy is experiencing inflation, some people gain whilst others lose out. How much they gain will depend on the rate of inflation

Groups made worse off with inflation

Individuals on fixed wages or incomes such as;

Individuals who's wages are fixed by contracts
Individuals who receive fixed pensions (private or government)
landlords who receive fixed rent incomes
Individuals who recieve fixed transfer payments from the governments such as unemployment benefits

All of the above groups will see their real income decrease with higher rates of inflation as the income payment is fixed but average price levels are rising

Individuals who's incomes rise at a slower rate than the rate of inflation

Holders of cash

Holders of cash do not receive any form of interest compared to those who keep their income in the bank. As inflation rises, the purchasing power of cash decreases, leaving these groups to be worse off. This can be especially an issue for lower income groups who may be unable to access financial institutions, especially in developing economies and can worsen the distribution of income.

Savers

If the rate of interest received by an individual saving in a bank is less than the rate of inflation, then the value of that individual's savings is decreasing. For example, if an individual was to receive 3% interest on their savings but the rate of inflation was 5%, the purchasing power or real income of the individual's savings will be decreasing 2% per year and so the individual will be worse off.

Lenders (Creditors)

Financial institutions such as banks will be worse off with high rates of inflation. This is because high rates will reduce the value of a loan that is being paid back over a period of time. Take for example if an individual takes out a $5000 loan over a two year period. With high rates of inflation, the $5000 the bank receives back after two years will be worth less than when the bank initially gave the loan. This is why the bank charges an interest rate on the loan, to ensure the value of the loan is the same after the time period. Higher rates of inflation however can still cause the lender to be worse off if the rate of interest is less than the rate of inflation.

Groups made better off with Inflation

Borrowers

Higher rates of inflation reduce the value of a loan. Borrowing at a lower rate of interest and a higher rate of inflation will reduce the value of the loan. For the borrower, so long as the rate of interest is less than the rate of inflation they will be better off.

Payers of fixed incomes

Those who pay fixed incomes such as pension firms or governments are made better off with higher rates of inflation. This is because those paying the fixed income are paying the nominal value agreed before. As such they will continue paying the nominal income despite the higher rate of inflation.

Firms paying wage increases lower than the rate of inflation

As with those on fixed incomes, if firms are paying workers a lower pay increase compared to the rate of inflation, they will be better off. This is because they will gain from the higher average price levels but a lower increase in their costs of production (labour costs).

Consequences of Deflation

Causes of Deflation

Deflation can be caused by either a decrease in Aggregate Demand, resulting in lower levels of output and rising unemployment. This is considered "Bad Deflation" due to the negative effects on output and unemployment.

Similarly, deflation may occur due to an increase in SRAS, which results in a lower average price level however with an increase in the real GDP. This is sometimes referred to as "Good Deflation" due to the fact it occurs with an in Real GDP. However, as we will see below, the consequences of Deflation are just as bad for an economy as those associated with high Inflation.

Costs of Deflation

Deflation increases the real value of debt

Redistribution effects - opposite to the effects mentioned above, deflation causes those on fixed incomes, savers and lenders to be better off, whilst making the borrowers worse off as the value of their debt has risen

Uncertainty - As with high inflation, deflation causes uncertainty for firms as they will be unable to predict revenues and costs, leading to lower business confidence and therefore lower levels of investment.

Deferred Consumption - As consumers speculate that prices will continue to decrease in the future due to deflation, households may not consume goods in the present and instead wait for prices to fall. This causes a decrease in Consumer Spending, hence decreasing levels of AD, leading to lower levels of economic output. Deflation, also deters households from borrowing money, again reducing consumer spending. All of this can lead to a deflationary spiral.

Difficulty to fix Deflationary Spirals - Once economies find themselves in a deflationary spiral, it can be difficult for governments to fix the problem by using monetary or fiscal policy. As households continue to expect prices to fall, they reduce their spending, which can be difficult to restore consumer confidence and increase the levels of consumer spending.

Diagram 1: A "Bad" Deflationary Spiral

Case Study: Deflation in Japan

Deflation fears creep back in Japan as pandemic hits pricesConsumer prices in Japan's capital city fell for the first time in three years in April and national factory activity slumped, data showed on Friday, increasing worries the coronavirus pandemic could tip the country back into deflation.

Consequences of Hyperinflation

Hyperinflation and high inflation both involve a rapid increase in the general price level of goods and services within an economy, but they differ significantly in terms of scale and consequences.

High inflation typically refers to a sustained increase in the overall price level of goods and services over a period of time, often measured annually. While high inflation can erode purchasing power, disrupt economic planning, and redistribute income and wealth, it is usually manageable through appropriate monetary and fiscal policies.

On the other hand, hyperinflation is an extreme form of inflation characterized by extremely rapid and out-of-control price increases, often exceeding 50% per month. Hyperinflation typically results from a collapse in the value of a nation's currency, usually due to excessive money creation by the government or central bank, often to finance large budget deficits or war efforts. The consequences of hyperinflation can be severe and wide-ranging:

Loss of Confidence: Hyperinflation erodes confidence in the currency and undermines trust in the economy, leading to panic buying, hoarding, and speculative activities.
Wealth Destruction: Savings and fixed-income investments rapidly lose value, causing significant wealth destruction for households and businesses. This can particularly impact those on fixed incomes or with limited access to assets that hedge against inflation.
Impaired Economic Functioning: Hyperinflation disrupts normal economic activity as businesses struggle to set prices, plan production, and make investment decisions amid extreme uncertainty.
Distorted Resource Allocation: Hyperinflation distorts resource allocation as individuals and businesses prioritize short-term survival strategies over long-term investments, leading to inefficient use of resources.
Social Unrest: Hyperinflation often leads to social unrest, protests, and political instability as citizens become increasingly frustrated with the deteriorating economic conditions and the government's inability to address them effectively.
Destruction of Savings and Retirement Plans: Hyperinflation can wipe out savings and retirement plans, leaving individuals and families financially vulnerable and exacerbating social inequality.
Currency Substitution: In extreme cases, hyperinflation can lead to the complete loss of confidence in the domestic currency, prompting people to switch to more stable foreign currencies or alternative stores of value, further undermining the domestic economy.

Governments and central banks typically respond to hyperinflation with drastic measures, such as imposing price controls, issuing a new currency, or adopting a foreign currency as legal tender. However, these measures often come with their own set of challenges and can be difficult to implement effectively. Therefore, preventing hyperinflation through prudent monetary and fiscal policies is crucial for maintaining economic stability and preserving the purchasing power of the currency.

Case Study: Hyperinflation in Venezuela

Venezuela has been struggling with hyperinflation since 2015. Prices have been rising year on year. As we can see prices were rising in the hundreds of percentage from 2015, rising 121.74% compared to the year before, this spiked with prices rising in 2018 65,374% compared to 2017. Whilst the increase in prices has slowed, prices are still expected to increase by 6500% in 2021 to 2020

Wages were only rising on average 60%, leading to a real terms decrease in households purchasing power.

This chart shows the time taken for the Venezuelan Bolivar to lose 90% of its value. As we can see, in 2011 it would take between 8-32 years for the Bolivar to lose 90% of its value. However, from 2012 onwards, this number decreased to taking around a year to lose 90% of its value and by 2019 it was taking approximately 3 months for the Bolivar to lose 90% of its value due to the hyperinflation Venezuela was experiencing.

This chart shows the speed with which the Bolivar was losing its value and as such, how fast households purchasing power was decreasing.

The video above talks about the effects of the hyperinflation on the Venezuelan economy and economic activity

Venezuela: The Rise and Fall of a PetrostateVenezuela’s descent into economic and political chaos in recent years is a cautionary tale of the dangerous influence that resource wealth can have on developing countries.

The following article provides more details on the Venezuelan crisis, including understanding both the political and humanitarian crisis brought on by the economic impacts of hyperinflation.

Since the crisis began, more than 5.4 million Venezuelans have left the country to escape the economic hardship brought on by the economic crisis.

The video above can help visualise the effects on inflation on purchasing power.

Venezuela's Maduro warns of new price controls as inflation spikesVenezuelan President Nicolas Maduro warned on Wednesday that strict price controls on basic goods could return, as the coronavirus outbreak and an acute gasoline shortage prompt inflation to accelerate.

The following article looks at the policies of price controls (price ceilings) used to try to combat the large increases in the price levels on basic necessities and the impacts of shortages of foods.

Page updated

Google Sites

Report abuse