EFFECTS OF

INFLATION

Project done by:

Ranjeet Ramaswamy Iyer

wdp420059@gmail.com
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.

• 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 account in the economy.

• 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.

• 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 terms 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

account, 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 terms related to inflation:

• Deflation: a fall in the general price level.

• Disinflation: a decrease in the rate of inflation.

• Hyperinflation: an out-of-control inflationary spiral.

• Stagflation: a combination of inflation, slow economic growth and

high unemployment.

• Reflation: an attempt to raise the general level of prices to counteract

deflationary pressures.

• 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.

• The growth in the output of goods and services is exceedingly inferior

to the money printed out.

• Imbalance between supply and demand caused by the above events.

• Total loss of confidence in the money (because of its ever decreasing

value).

• Enactment of legal tender laws and price controls to prevent

discounting the value of paper money relative to gold, silver, hard
currency, or commodities.

• Failure of the above measures to force acceptance of a paper money

which lacks intrinsic value.

• If the entity responsible for printing a currency promotes excessive

money printing, with other factors contributing a reinforcing effect,
hyperinflation usually continues.
 • 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.

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

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

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

• The economy is distorted in favor of extreme consumption and

hoarding of real assets.

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

(Germany):
Germany 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
Germany'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 Germany 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 about USD 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 about USD 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 surpassing 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.