Inflation
generally redistributes wealth (income) among various individual (organizations)
in the society. This redistribution is done arbitrarily, leaving some better
off and others worse –off. In addition, inflation affects production and growth
negatively by distorting aggregate demand supply and misallocating societal
resources. In general, the effect of inflation on individuals, business
organizations and the economy as a whole will depend on whether such inflation
was anticipated or unanticipated, and, on the rate of inflation. We shall
examine these general effects by looking at those who are made better off by
inflation and those are made worse-off.
generally redistributes wealth (income) among various individual (organizations)
in the society. This redistribution is done arbitrarily, leaving some better
off and others worse –off. In addition, inflation affects production and growth
negatively by distorting aggregate demand supply and misallocating societal
resources. In general, the effect of inflation on individuals, business
organizations and the economy as a whole will depend on whether such inflation
was anticipated or unanticipated, and, on the rate of inflation. We shall
examine these general effects by looking at those who are made better off by
inflation and those are made worse-off.
Those who are better – off
Those who anticipated the rise
in prices
in prices
Persons
or organizations that anticipated inflation before it occurs often stand to
gain in the event of such general rise in prices. This is because they would
have made provisions to counter the effect of such increases on their demand
and expenditure patterns and to make possible gains from the increases.
or organizations that anticipated inflation before it occurs often stand to
gain in the event of such general rise in prices. This is because they would
have made provisions to counter the effect of such increases on their demand
and expenditure patterns and to make possible gains from the increases.
Owners of real assets and
Speculators
Speculators
This
group of persons benefit from inflation because the value of their assets
increase with the inflationary trend. Assets like lands, buildings, appreciate
over time. The rate of appreciation is heightened during times of inflation. In
addition, when people expect prices to rise (anticipate inflation), they tend
to increase their purchases of real and financial assets, consumer durables and
even, at some times, ordinary consumer goods with the intent of reselling them
at higher prices in future. Such an act is called speculation in economic
parlance.
group of persons benefit from inflation because the value of their assets
increase with the inflationary trend. Assets like lands, buildings, appreciate
over time. The rate of appreciation is heightened during times of inflation. In
addition, when people expect prices to rise (anticipate inflation), they tend
to increase their purchases of real and financial assets, consumer durables and
even, at some times, ordinary consumer goods with the intent of reselling them
at higher prices in future. Such an act is called speculation in economic
parlance.
Debtors
Debtors
or borrowers gain when there is inflation, since they have to pay back their
debts in cash with a lower real value (purchasing power). The situation has
changed, however, in recent times, especially in developed countries and in
cases that involves institutional creditors such as banks and other financial
institutions. Most institutional creditors normally build in an additional
interest above the nominal market interest rate as compensation and protection
against inflation. This additional interest rate is called the inflation
premium. According to the fisher’s hypothesis, a ten percent increase in
inflation for example, is to be accompanied by a 10% increase in the interest
rate. In sum, debtors having debts with zero or fixed interest rates usually
gain at the expense of creditors during times of inflation.
or borrowers gain when there is inflation, since they have to pay back their
debts in cash with a lower real value (purchasing power). The situation has
changed, however, in recent times, especially in developed countries and in
cases that involves institutional creditors such as banks and other financial
institutions. Most institutional creditors normally build in an additional
interest above the nominal market interest rate as compensation and protection
against inflation. This additional interest rate is called the inflation
premium. According to the fisher’s hypothesis, a ten percent increase in
inflation for example, is to be accompanied by a 10% increase in the interest
rate. In sum, debtors having debts with zero or fixed interest rates usually
gain at the expense of creditors during times of inflation.
Businesses and certain
categories of workers
categories of workers
Most
businesses gain in periods of inflation because prices often rise faster than
cost of production (especially wages), leading to higher profits. A general
rise in prices occasioned by an increase in the price of motor fuel, for
example, will cause transporters to increase prices. But quite often, the rate
of increase in transport cost will be far above the rate of increase in fuel
price thus implying larger profits. The same is true for traders and other
former business organization. Certain categories of workers whose wages adjust
quickly to price changes also benefit from inflation (at least temporarily). In
particularly, there are workers whose employment contract includes a cost –of-living
adjustment (COLA) clause. The COLA is a clause found in some wage contract to
compensate workers partly or fully for any erosion in their purchasing power
caused by inflation.
businesses gain in periods of inflation because prices often rise faster than
cost of production (especially wages), leading to higher profits. A general
rise in prices occasioned by an increase in the price of motor fuel, for
example, will cause transporters to increase prices. But quite often, the rate
of increase in transport cost will be far above the rate of increase in fuel
price thus implying larger profits. The same is true for traders and other
former business organization. Certain categories of workers whose wages adjust
quickly to price changes also benefit from inflation (at least temporarily). In
particularly, there are workers whose employment contract includes a cost –of-living
adjustment (COLA) clause. The COLA is a clause found in some wage contract to
compensate workers partly or fully for any erosion in their purchasing power
caused by inflation.
Government
Since
the income tax in most countries is progressive, the government collects
proportionately more taxes as inflation and the accompanying increases in
nominal wages pushes people into higher tax brackets. In addition, the
government gains when it pays its creditors (holders of government bonds,
treasury certificates etc) interest on debts with a currency whose purchasing
power has fallen. Because it redistributes income from private to public hands,
inflation is often considered a disguised form of taxation.
the income tax in most countries is progressive, the government collects
proportionately more taxes as inflation and the accompanying increases in
nominal wages pushes people into higher tax brackets. In addition, the
government gains when it pays its creditors (holders of government bonds,
treasury certificates etc) interest on debts with a currency whose purchasing
power has fallen. Because it redistributes income from private to public hands,
inflation is often considered a disguised form of taxation.
The Macro economy
The
economy as a whole could gain from a slightly inflationary situation if it was
at a less than full employment position before the occurrence of the inflation.
This is because at such times, a general rise in the price level may stimulate
production of goods and services, which in turn enhance the employment of
hitherto idle productive factors.
economy as a whole could gain from a slightly inflationary situation if it was
at a less than full employment position before the occurrence of the inflation.
This is because at such times, a general rise in the price level may stimulate
production of goods and services, which in turn enhance the employment of
hitherto idle productive factors.
Those Who Loses
Holders of Money Assets
Inflation
erodes the real value of a given sum of money by reducing its purchasing power.
Thus, during periods of inflation, holders of money or financial assets suffer
since such assets can now be transformed into smaller quantities of goods and
services as compared to the pre-inflation period.
erodes the real value of a given sum of money by reducing its purchasing power.
Thus, during periods of inflation, holders of money or financial assets suffer
since such assets can now be transformed into smaller quantities of goods and
services as compared to the pre-inflation period.
Creditors (Formal, Informal)
In
general, creditors suffer during periods of inflation because they receive in
return for money lent out, an equivalent amount of cash but with a lower real
value. Creditors may be informal money lenders, bond and/or treasury
certificate holders (creditors to government or other organizations) and bank
and non-bank financial institutions. However, as mentioned earlier, because of
the growing phenomenon of rising prices and the risk associated with it, most
institutional creditors often provide for an inflation premium when entering
into the loss the creditor would have suffered in the event of a general rise
in the price level.
general, creditors suffer during periods of inflation because they receive in
return for money lent out, an equivalent amount of cash but with a lower real
value. Creditors may be informal money lenders, bond and/or treasury
certificate holders (creditors to government or other organizations) and bank
and non-bank financial institutions. However, as mentioned earlier, because of
the growing phenomenon of rising prices and the risk associated with it, most
institutional creditors often provide for an inflation premium when entering
into the loss the creditor would have suffered in the event of a general rise
in the price level.
Businesses and Workers
(including pensioners)
(including pensioners)
For
some business persons or organizations, inflation may cause severe harm. This
is especially true for business agreements that take the form of medium or
long-term contracts. The emergence of inflation during the course of executing
the contract will push up prices of needed inputs making it impossible for the
contract to be concluded at the agreed cost. Where an upward review of the
contract sum cannot be secured, the contractor either incurs a loss or the job
is abandoned. The same is true for any other business requiring continuous injection
of funds over a given period.
some business persons or organizations, inflation may cause severe harm. This
is especially true for business agreements that take the form of medium or
long-term contracts. The emergence of inflation during the course of executing
the contract will push up prices of needed inputs making it impossible for the
contract to be concluded at the agreed cost. Where an upward review of the
contract sum cannot be secured, the contractor either incurs a loss or the job
is abandoned. The same is true for any other business requiring continuous injection
of funds over a given period.
The
amount budgeted for the project becomes inadequate when there is a general rise
in prices. Apart from business organizations or individuals, inflation also
adversely affect workers whose wages does not adjust to reflect the cost of
living. Most civil servants (at least in developing countries) fall into this
category. In addition to these are pensioners with fixed monthly payment.
Inflationary situations leave such persons worse-off, affecting their standard
of living negatively. In societies where prices are sticky downwards (i.e., where
prices do not go down to their previous levels once they have risen), the
situation can be very unbearable.
amount budgeted for the project becomes inadequate when there is a general rise
in prices. Apart from business organizations or individuals, inflation also
adversely affect workers whose wages does not adjust to reflect the cost of
living. Most civil servants (at least in developing countries) fall into this
category. In addition to these are pensioners with fixed monthly payment.
Inflationary situations leave such persons worse-off, affecting their standard
of living negatively. In societies where prices are sticky downwards (i.e., where
prices do not go down to their previous levels once they have risen), the
situation can be very unbearable.
Taxpayers
For
most countries, the income tax structure is progressive. What this mean is that
the higher your income, the greater the proportion of the income that is paid
as taxes. Now, if the money income of workers is increased to compensate for
inflation, for example, the increase in nominal wages will push workers into a
higher tax bracket even though their purchasing power (their real money income)
has not changed (since the rise in money wage is offsite by the rise in
prices).In other words, workers will now pay a higher proportion of their
income as taxes even though they are on the same real income level. Hence, tax
payers suffer under a progressive tax system whenever there is an increase in
wages, which is offsite by an increase in the price level.
most countries, the income tax structure is progressive. What this mean is that
the higher your income, the greater the proportion of the income that is paid
as taxes. Now, if the money income of workers is increased to compensate for
inflation, for example, the increase in nominal wages will push workers into a
higher tax bracket even though their purchasing power (their real money income)
has not changed (since the rise in money wage is offsite by the rise in
prices).In other words, workers will now pay a higher proportion of their
income as taxes even though they are on the same real income level. Hence, tax
payers suffer under a progressive tax system whenever there is an increase in
wages, which is offsite by an increase in the price level.
To
fix ideas, consider an individual who pays ten percent of his monthly income as
tax. Assume that there is a rise in the general price level and in order to
compensate workers (i.e., to keep them their existing living standard) wages
are increased proportionately. Assume further that the increase in the
individual’s wages pushes him up to a tax bracket where he now pays fifteen
percent of his income as taxes. Is the individual better off or worse off? The
answer obviously lies in the latter; because the individual’s real income has
fallen by the increase in taxes. In other words, he can now purchase fewer
goods with his net income than before the increase.
fix ideas, consider an individual who pays ten percent of his monthly income as
tax. Assume that there is a rise in the general price level and in order to
compensate workers (i.e., to keep them their existing living standard) wages
are increased proportionately. Assume further that the increase in the
individual’s wages pushes him up to a tax bracket where he now pays fifteen
percent of his income as taxes. Is the individual better off or worse off? The
answer obviously lies in the latter; because the individual’s real income has
fallen by the increase in taxes. In other words, he can now purchase fewer
goods with his net income than before the increase.
The
individual was better-off without the inflation and the corresponding increase
in income. The loss of purchasing power that occurs when people are pushed into
higher tax brackets by inflation as money income rises but real income remains
the same, is called taxflation, employers of labor (primarily the government) gains
at the expense of taxpayers in the event of such bracket creeping. In fact, some
feel that the phenomenon of fiscal drag2 may in itself encourage
government to pursue inflationary policies. However, where tax brackets are
indexed (adjusted to take care of inflation or reflected in terms of real
rather than nominal income), the problem of tax flation is removed.
individual was better-off without the inflation and the corresponding increase
in income. The loss of purchasing power that occurs when people are pushed into
higher tax brackets by inflation as money income rises but real income remains
the same, is called taxflation, employers of labor (primarily the government) gains
at the expense of taxpayers in the event of such bracket creeping. In fact, some
feel that the phenomenon of fiscal drag2 may in itself encourage
government to pursue inflationary policies. However, where tax brackets are
indexed (adjusted to take care of inflation or reflected in terms of real
rather than nominal income), the problem of tax flation is removed.
The Macro economy and Society
at Large
at Large
In
the long run, inflation hurts the macro economy and the society at large. When
there is a persistent rise in prices, there is a loss of confidence in the
economy and entrepreneurial and managerial talents are diverted away from
production (and manufacturing) to speculation, maneuvering and seeking avenues
for protection or benefits from inflation. Buying and selling displaces
manufacturing and the economy is overheated. Goods are stockpiled in warehouses
with the hope of selling at higher prices. At the international level, the country’s
domestically produced goods become relatively more expensive compared to
imports. This diverts spending away from the former to the latter thus
affecting the country’s balance of payments. The country is also worse-off
socially. Inflation produces a distortion in the spending and consumption
patterns of individuals.
the long run, inflation hurts the macro economy and the society at large. When
there is a persistent rise in prices, there is a loss of confidence in the
economy and entrepreneurial and managerial talents are diverted away from
production (and manufacturing) to speculation, maneuvering and seeking avenues
for protection or benefits from inflation. Buying and selling displaces
manufacturing and the economy is overheated. Goods are stockpiled in warehouses
with the hope of selling at higher prices. At the international level, the country’s
domestically produced goods become relatively more expensive compared to
imports. This diverts spending away from the former to the latter thus
affecting the country’s balance of payments. The country is also worse-off
socially. Inflation produces a distortion in the spending and consumption
patterns of individuals.
The
loss of production that accompanies the persistent and general rise in prices
leads to retrenchment of workers and increases in the rate of unemployment, the
inability of workers and individuals to make ends meet encourages corrupt
practices and generate social unrest and vices. Thus, in the long run, high and
persistent increases in the price level may spell doom for a country.
loss of production that accompanies the persistent and general rise in prices
leads to retrenchment of workers and increases in the rate of unemployment, the
inability of workers and individuals to make ends meet encourages corrupt
practices and generate social unrest and vices. Thus, in the long run, high and
persistent increases in the price level may spell doom for a country.