Effects Of Inflation 3z3n6l

EFFECTS OF INFLATION

Project done by: Ranjeet Ramaswamy Iyer [email protected]

Inflation: •

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.

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When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of in the economy.

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A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.

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Inflation can have positive and negative effects on an economy. Negative effects of inflation include loss in stability in the real value of money and other monetary items over time; uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects

include a mitigation of economic recessions, and debt relief by reducing the real level of debt.

A view of inflation in different countries of the world in 2007

Effects of Inflation  Effects of inflation depend upon the nature of inflation.

 Factors such as rate of inflation, whether it is stable, accelerating or decelerating, whether it is anticipated or unanticipated determine the consequences of inflation.  For e.g. Inflation in Zimbabwe is 11.2 mn %. If such a situation

occurs, then the consequences will be in of complete loss of faith in money circulated by the Central Bank in the country.  When rate of inflation increases every year, then it is known as accelerating inflation.  During an accelerating inflation, trade unions & firms will demand wage revision & determine product prices.  Accelerating inflation leads to uncertainty due to which hoarding of

goods takes place. This is further increase the inflation.  When inflation rate changes i.e. increases or decreases in minute quantities, then it is known as Stable Inflation.  When inflation rate is exactly or approximately similar to what is predicted, it is known as Anticipated Inflation.  When inflation rate is less that or greater than the expected rate, it is known as Unanticipated Inflation rate.  In the context of international trade and price competitiveness, if the

domestic inflation rate is higher than the inflation rate in competing countries, then it will make exports less competitive in the international markets and create balance of payment problems.

 Inflation is a theft of income of the unprotected segments of society.  Inflation is a crime against the poor who experience a fall in their real incomes during a period of sustained price rise.  Inflation affects 3 main functions of economy viz. Production, Consumption and Distribution.

Effect on production and economic growth:  In economies, where labor is largely unorganized, single digit inflation will increase profitability and therefore lead to greater investment, employment, output, income, demand and prices.  This happens because wages of unorganized laborers is not indexed to inflation, so wages will fall overtime during inflation whether it is anticipated or not.  In case of anticipated inflation, the real wages of organized labor will also fall and may be compensated with a time lag.  The firms will gain during the intervening period between anticipated price rise and its compensation to labor.  Thus, from the point of view of production and economic growth, single digit inflation has positive impact.

Effect on distribution of income and wealth:  The impact of inflation with regard to distribution of income and

wealth is not even on all sections of our society.  Organized laborer’s salaries and wages are indexed to inflation.

 Debtors become advantageous as during inflation the value of real interest may fall down and creditors face a big disadvantage.  Hence during inflation, rich become richer and poor become poorer.

Effect on consumption and economic welfare:  Inflation reduces the purchasing power of money earned by the poor and their economic welfare.  The workers who do not get compensated for the increase in price rise, experience reduction in real incomes because their nominal income remains constant for a long period.  Economic welfare depends upon consumption of goods and services.

During inflation, people consume fewer amounts of goods and services as a result the economic welfare gets affected.

The overall positive and negative effects of inflation are listed under: Most effects of inflation are negative, and can hurt individuals and companies alike, below are a list of negative and “positive” effects of inflation:

Negative effects are: 1. Hoarding (people will try to get rid of cash before it is devalued, by hoarding food and other commodities creating shortages of the hoarded objects).

2. Distortion of relative prices (usually the prices of goods go higher, especially the prices of commodities).

3. Increased risk - Higher uncertainties (uncertainties in business always exist, but with inflation risks are very high, because of the instability of prices).

4. Income diffusion effect (which is basically an operation of income redistribution).

5. Existing creditors will be hurt (because the value of the money they will receive from their borrowers later will be lower than the money they gave before).

6. Fixed income recipients will be hurt (because while inflation increases, their income doesn’t increase, and therefore their income will have less value over time).

7. Increased consumption ratio at the early stages of inflation (people will be consuming more because money is more abundant and its value is not lowered yet).

8. Lowers national saving (when there is a high inflation, saving money would mean watching your cash decrease in value day after day, so people tend to spend the cash on something else).

9. Illusions of making profits (companies will think they were making profits while in reality they’re losing money if they don’t take into consideration the inflation rate when calculating profits).

10.Causes an increase in tax bracket (people will be taxed a higher percentage if their income increases following an inflation increase).

11.Causes mal-investment (in inflation times, the data given about an investment is often deceptive and unreliable, therefore causing losses in investments).

12.Causes business cycles (many companies will have to go out of business because of the losses they incurred from inflation and its effects).

13.Currency debasement (which lowers the value of a currency, and sometimes cause a new currency to be born)

14.Rising prices of imports (if the currency is debased, then it’s purchasing power in the international market is lower).

"Positive" effects of inflation are: 1. It can benefit the inflators (those responsible for the inflation)

2. It be benefit early and first recipients of the inflated money (because the negative effects of inflation are not there yet).

3. It can benefit the cartels (it benefits big cartels, destroys small sellers, and can cause price control set by the cartels for their own benefits).

4. It might relatively benefit borrowers who will have to pay the same

amount of money they borrowed (+ fixed interests), but the inflation could be higher than the interests, therefore they will be paying less money back. (example, you borrowed $1000 in 2005 with a 5% fixed interest rate and you paid it back in full in 2007, let’s suppose the inflation rate for 2005, 2006 and 2007 has been 15%, you were charged %5 of interests, but in reality, you were earning %10 of interests, because 15% (inflation rate) – 5% (interests) = %10 profit, which means you have paid only 70% of the real value in the 3 years. Note: Banks are aware of this problem, and when inflation rises, their interest rates might rise as well. So don't take out loans based on this information.

5. Many economists favor a low steady rate of inflation, low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reducing the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping

the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.

6. Tobin effect argues that: a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects.

7. The first three effects are only positive to a few elite, and therefore might not be considered positive by the general public.

How to survive inflation? The following are some tips to survive during inflation: 1. Be wise when holding cash, whether in your home or in your savings , if you’re earning 5% interest on the money you have in your bank, and inflation rate is 10% then you’re in reality losing 5% and not earning anything.

2. Be careful when buying bonds, high inflation rates completely destroy the value of long-term bonds.

3. If you have a variable-rate mortgage, fix it if you can find a good deal, have a low fixed interest rate or 0% interest if you can find one.

4. Invest in durable goods or commodities rather than in money. Check out our commodities list.

5. Invest in things that you're going to use anyway and will serve you for a long time.

6. Invest for long-term capital gains, because short term investments tend to give deceptive results or sense of making profits while in reality you’re not making profits.

7. Learn about bartering which is trading goods or services without the exchange of money (it was very popular in hyperinflation times).

8. Manage wisely your recurring monthly bills such as (phone bills, cable TV...), it would help to reduce them or eliminate some of them.

9. Same goes with ephemeral items (movies, restaurants, hotel rooms...) they’re not bad if you spend money on them in moderation.

10.Ask yourself, do I really need these things I’m spending my money on? Think how much and how often you will need something before buying it.

11.Use the money saving tips such as: you need to reduce your consumption of things that are rising rapidly in price (eg, gas) without having to reduce your consumption of goods that are rising less rapidly or even falling in price (eg, clothes).

12.Buy only what you need, especially objects that have multi-tasks, and are considered durable goods.

The conclusion from all this is: You don’t have to live cheap, just live smart!

Other related to inflation:

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Deflation: a fall in the general price level.

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Disinflation: a decrease in the rate of inflation.

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Hyperinflation: an out-of-control inflationary spiral.

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Stagflation: a combination of inflation, slow economic growth and high unemployment.

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Reflation: an attempt to raise the general level of prices to counteract deflationary pressures.

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Depression: a severe and prolonged recession characterized by inefficient economic productivity, high unemployment and falling price levels.

Hyperinflation: Hyperinflation could be defined as a very high inflation, a condition in which prices increase rapidly as a currency loses its value. In numbers, hyperinflation could mean a cumulative inflation rate over three years approaching 100% to an inflation exceeding 50% a month, in other words, let’s say today is June 1st 2009, if you have $20 today, with an inflation of 100% a month, your $20 will only have the value of $2.50 at the end of the September 2009, that would mean that you’re living in hyperinflation times. During hyperinflations, frequently people go back to trading and bartering and this way, it was very common in the Weimar Republic, and in recently in Zimbabwe, the buyers and sellers do not have to worry about the loss of the value of money. For example, in a healthy economy the corn sales man can sell them for money and then change this money in for gas for his tractor. But during hyperinflation, while he is selling the corn for money and buys gas for his tractor, the price of gas could have increased so much that he is not longer able to buy gas for his tractor, so they chose the “safer” option which is to barter. It’s is also important to understand this phenomenon in order to survive it or minimize its damage, note that hyperinflation is often associated with wars, their aftermath, or in economic depressions.

Causes of Hyperinflation: A hyperinflation is mainly caused by an extremely rapid growth in the supply of paper money. This occurs when the monetary and fiscal authorities of a nation regularly issue large quantities of money to pay for a large stream of government expenditures. In fact, inflation is a form of taxation in which the government gains at the expense of those who hold money while its value is declining. So many economists consider hyperinflation as a very large taxation scheme.

Here are some factors that could cause or trigger hyperinflation: •

Rapid and massive increase in the amount of money printed.

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The growth in the output of goods and services is exceedingly inferior to the money printed out.

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Imbalance between supply and demand caused by the above events.

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Total loss of confidence in the money (because of its ever decreasing value).

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Enactment of legal tender laws and price controls to prevent discounting the value of paper money relative to gold, silver, hard currency, or commodities.

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Failure of the above measures to force acceptance of a paper money which lacks intrinsic value.

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If the entity responsible for printing a currency promotes excessive money printing, with other factors contributing a reinforcing effect, hyperinflation usually continues.

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Often the body responsible for printing the currency cannot physically print paper currency faster than the rate at which it is devaluing, thus neutralizing their attempts to stimulate the economy.

To know if you're living in a hyperinflation times, check for the symptoms: •

People prefer to keep their wealth in non-monetary assets or in a relatively stable foreign currency.

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People regard monetary amounts not in of the local currency but in of a relatively stable foreign currency. Prices may be quoted in that foreign currency.

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Sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period.

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The purchasing power of private and public savings is wiped out.

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The economy is distorted in favor of extreme consumption and hoarding of real assets.

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Causes the monetary base, whether specie or hard currency, to flee the country.

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People tend to barter instead of using money as a way of exchanging goods.

In short, the major causes for a hyper inflation are an unchecked increase in the money supply (or drastic debasement of coinage) usually accompanied by a widespread unwillingness to hold the money for more than the time needed to trade it for something tangible to avoid further loss.

Effects of Hyperinflation: Hyperinflation effects are almost similar to high inflation effects, except that they’re more serious, the most serious consequence of hyperinflation is the reallocation of wealth. It transfers wealth from the general public, which holds money, to the government, which issues money. Hyperinflations also cause borrowers to gain at the expense of lenders when loan contracts are signed prior to the worst inflation. Check out more effects by visiting our page above.

Hyperinflation in History: Hyperinflation is not a particularly uncommon episode in human history. It has occurred in the following countries: Weimar Republic of 1920 – 23 (466 billion percent from starting value), Zimbabwe 2003 - Now (231 million percent from starting value), Argentina 1975 – 1983 (1,000 percent from starting value), Bosnia-Herzegovina 1992 – 93 (100,000 percent from starting value). Here are some common examples in more details:

Hyperinflation in the Weimar Republic (): or the Weimar Republic at the time went through its worst inflation in 1923. The highest denomination was 100,000,000,000,000 Mark which was the equivalent of about 25 USD. The rate of inflation hit 3.25 × 106

percent per month (prices double every two days). Beginning on November 20, 1923, 1,000,000,000,000 old Marks were exchanged for 1 Rentenmark so that 4.2 Rentenmarks were worth 1 US dollar, exactly the same rate the Mark had in 1914. The hyperinflation episode in the Weimar Republic in the 1920s was not the first hyperinflation, nor was it the most serious, compared to the Zimbabwean Dollar for example. The main cause of the Weimar Republic hyperinflation is believed to be because of the "London ultimatum" in May 1921 which demanded reparations in gold or foreign currency to be paid in annual installments of 2,000,000,000 (2 billion) gold marks plus 26 percent of the value of 's exports. The first payment was paid when due in August 1921. That was the beginning of an increasingly rapid devaluation of the Mark which fell to less than one third of a cent by November 1921 (approx. 330 Marks per US Dollar). The total reparations demanded was 132,000,000,000 (132 billion) gold marks which was far more than the total German gold or foreign exchange. An attempt was made by to buy foreign exchange, but that was paid in treasury bills and commercial debts for Marks which only increased the speed of devaluation. But some believe that the government found reparations a convenient excuse and that there might be other reasons that might have triggered the hyperinflation. Other possible causes included bankers and speculators (particularly foreign), both of which groups had, in fact, exacerbated the hyperinflation through the normal course of their profit-seeking. The inflation reached its peak by November 1923, but ended when a new currency (the Rentenmark) was introduced. The government stated that this new currency had a fixed value, secured by real estate, and this was accepted.

Hyperinflation in Zimbabwe: Hyperinflation was not a common place for Zimbabwe, because 30 years ago the Zimbabwe dollar was worth D 1.25. However in July 22nd, 2008, the value of the ZWD had fallen to approximately 688 billion per 1 USD. Since the country’s independence, rampant inflation and the collapse of the economy have severely devalued the currency, causing many organizations to favor using the US dollar or South African rand instead. Inflation was stable until Robert Mugabe began a program of land reforms that primarily focused on taking land from white farmers and redistributing those properties and assets to black farmers; this in turn sent food production and revenues from export of food plummeting, one more main reason that contributed to inflation in Zimbabwe was a monetary phenomena (the result of Mugabe's government printing money) as can be seen by the appearance of ever higher face value printed notes, whose face value exceeded the sum of all previously existing notes. Hyperinflation started to take shape very early in the 21st century Zimbabwe in the shape of chronic inflation at first. Inflation reached 624% in 2004, and then fell back to low triple digits before surging to a new high of 1,730% in 2006. During that time, the Reserve Bank of Zimbabwe revalued their currency on August 1, 2006 at a rate of 1,000 old Zimbabwean dollars to 1 revalued Zimbabwean dollar. In June 2007, inflation in Zimbabwe had risen to 11,000% year-to-year from an earlier estimate of 9,000%. On May 5th, 2008 the Reserve Bank of Zimbabwe issued bank notes or "bearer checks" for the value of ZWD 100 million and ZWD 250 million. Ten days later on May 15th, new bearer checks with a value of ZWD 500 million (then equivalent to D 2.5) were issued. Five days later on May 20th, a new series of notes in the form of "agro checks" were issued in denominations of ZWD 5 billion, ZWD 25 billion and ZWD 50 billion. An additional agro check was issued for ZWD 100 billion on July 21st. Meanwhile inflation has officially surged to 2,200,000% with some analysts estimating figures suring 9,000,000 percent. As of July 22nd, 2008, the value of the ZWD had fallen to approximately 688 billion per 1 USD, or 688

trillion pre-August 2006 Zimbabwean dollars. On August 1, 2008, the Zimbabwe dollar was redenominated by removing 10 zeroes. ZWD 10 billion became 1 dollar after the redenomination. On August 19, 2008, official figures announced for June estimated the inflation over 11,250,000 percent. Zimbabwe's annual inflation was 231,000,000% in July (Prices doubling every 17.3 days). At the beginning of November, 2008, the inflation rate was calculated to be at 516 quintillion percent (516,000,000,000,000,000,000%). The monthly inflation was 13.2 billion percent. Zimbabwe hyperinflation approached post Second World War Hungary's hyperinflation (Hungary: 12.95 quadrillion percent per month (195% daily), i.e. prices doubling every 15.6 hours. Zimbabwe: 79.6 billion percent per month (98.0%), i.e. prices doubling every 24.7 hours). On January 16, 2009, Zimbabwe issued a $100 trillion bill.

How to Avoid Hyperinflation: Hyperinflation affects almost everyone, therefore it's hard to avoid, but you can take some steps to minimize its negative effects and survive until it's over.

Bibiliography: 1. Wikipedia 2. Managerial Economics-II by Krishnan Nandela 3. Self Knowledge 4. Many other websites.