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Effects Of Inflation

December 3rd, 2009

Effects Of Inflation A small amount of inflation is viewed as having a beneficial effect on the economy. One reason for this is that it is generally difficult to renegotiate prices and wages once they are fixed to a level. With increasing prices it is easier for relative prices to adjust automatically.

Because of inflation, the price of any given good is likely to rise over time, hence consumers and businesses may choose to make purchases sooner than later before the worth of their money has eroded. This effect will keep an economy active in the short term by encouraging spending and borrowing. But inflation also reduces incentives to save, so the effect on savings and investments is negative. High or unpredictable inflation rates are regarded as bad.

Following are effects of inflation on individual, organizations and government:

  • Redistribution of wealth:
  • Inflation redistributes wealth from those on fixed incomes, such as pensioners, and shifts it to those who do not have a fixed income (income which takes into account cost of living), for example from wages and profits which may keep pace with inflation.
  • Individuals who are indebted in any way may be helped by inflation because of decrease in the real value of debt. As such, inflation siphons off wealth from those who lend to those who borrow.
  • Income tax brackets tend to become distorted. Governments that allow inflation to rise sharply are, in effect, allowing a tax increase because the same real purchasing power is being taxed at a higher rate.
  • Distorted Economic Decisions: If there is higher inflation, manufacturers that do not adjust their prices will have much lower prices relative to firms that adjust them. This will distort economic decisions. For eg: suppose iron ore prices rise while steel prices do not then steel manufacturers might want to buy steel available through other sellers rather than manufacturing themselves.
  • Rising inflation prompts workers to demand higher wages, to keep up with prices. Rising wages cause more money supply in the market which helps inflation rise. This can cause a spiral in wage and inflation.
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