Inflation can simply be referred to as the increase in the general price level of goods and services. Technically defined as a decliner in the purchasing power of any given currency over a period of time. The inflation rate or the rate of inflation is the rate at which the value of a currency depreciates. When the value of a currency depreciates and the real value of goods and services remains the same, it causes a rise in prices.
This fall in the value of currency and rise in the general price level has wide-ranging impacts on production, distribution of wealth, and the economy as a whole. These impacts may be positive or negative and the impact on groups of individuals can be different. This difference of impact may be due to the rate of change in inflation, the type of assets that the individual holds, and the role that the individual plays in the economy.
The root cause of inflation in an economy is the rise in the money supply. This increased money supply acts as a demand stimulator. As there is more money chasing the same quantity of goods as before, it results in increased demand giving rise to increased prices. The causes of inflation are broadly divided into three categories- Demand-Pull inflation in which the increased money supply in the economy gives rise to increased demand which pulls the prices up, Cost-Push inflation in which the rise in inputs of an economy increases thereby increasing the cost of production leading to increased price level and Built- in- inflation in which the expectation of the stakeholders for the inflation to continue actually drives the inflation.
Effects of inflation are wide-ranging in terms of the type of impact, recipient of impact, or even on the different economic scenarios. As mentioned earlier the impacts of inflation on production and distribution of wealth are prominent. The impact of inflation on production also depends on the type of inflation. If inflation is a cost-push, then there will be a decline in production as the increase in production cost will hamper the confidence as well as meet the budget constraints of the producer. In demand-pull inflation, there are high chances for an increase in production. The increase in money supply pushes the demand for goods and services up and this increased demand for existing goods will have a positive impact on the prices. As higher prices are a production incentive, the producers tend to ramp up their production to meet the high demand. The demand-pull inflation also has a short-run positive impact on the stakeholders of production including the laborers as they tend to receive a higher wage.
The effects of inflation on the distribution of wealth and income are similar to the effect on production as it affects different stakeholders in different ways. Commonly, inflation leads to an increased income level in the economy. But this increased income goes to a part of the whole population and the remaining are worsened off. During inflation increases in prices along with the rise in income can be advantageous for some and disadvantageous for others. This is because the income of some increases at a rate higher than the rate of inflation and the remaining people, particularly wage earners and low-income groups suffer as they cannot keep up with the high rise in prices.
The impact of inflation on individuals largely depends on their viewpoint as well as the role they play in the economy and therefore affects different categories of people differently. An entrepreneur gets a mixed bag as he has the opportunity to earn more profit cashing in on the higher prices and higher demand but also has other constraints. These constraints include the rise in wage rates for laborers and the need to pay increased salaries to employees. The entrepreneur also faces an extra burden of higher borrowing costs. This is because the investors expect a higher return for their investment as the value of the currency is declining and the only way to compensate for that is higher income. The increased input prices are also a hindrance to the profit earning objective of firms. To sum up the firms can enjoy a higher profit in the short run until the wage rate, interest rate, and input prices all increase.
Investors tend to gain during inflation owing to the higher profits of the firms. Lenders on the other hand would suffer a bit as they are repaid according to the old interest rate and in real terms, they receive less than what they deserve. The debtors will benefit as they repay less than what they actually owe in real terms. The debenture holders and bondholders also tend to lose as they get a fixed return and the slumped value of the currency is disadvantageous to them. The salaried class and wage earners are usually on the losing end as the rise in salaries and wages are always lesser than the rate of inflation.
To sum up, the general increase in price level also known as inflation affects the production and distribution of wealth in a multi-faceted manner owing to the classification of the type of inflation and the rate of it. Though inflation has a positive effect on production it is not believed to prolong. Inflation also plays a discriminatory role in the distribution of wealth and income as it makes the rich richer and the poor poorer. Inflation also has very different impacts on different categories of people.
1. How Does Inflation Affect Production, Positively or Negatively?
Ans: The answer to this question cannot be expressed objectively as the type of impact of inflation on production is multi-dimensional and depends on various factors. Inflation is commonly believed to make a positive impact on production as it is incentivizing for the firms. This is also because demand-pull inflation is the most common, especially in a highly populated country like India. If the inflation is cost-push, chances are that it causes a decline in production. Inflation also affects different types of industries differently. For example, the luxury goods industry would be definitely affected negatively. The type of impact of inflation therefore can only be determined individually, even though it is generally believed to make a positive impact.
2. Is inflation Good or Bad for the Economy?
Ans: The impact of inflation on the economy as a whole depends on the rate of inflation. No inflation or deflation is very dangerous for the economy; therefore, inflation can certainly be weighed better than deflation. Low to moderate inflation is essential for every economy to grow. If the economy has an inflation rate of 4-5% it incentivizes production moderately and in the long run, it will also lead to increased wage rates paving way for higher living standards in the country. This moderate inflation also has to be kept in check as an inflation cycle can lead to a double-digit inflation rate which can prove fatal to the middle and lower-income groups. Very high inflation rates are also not at all preferable for any economy.