Effects of Inflation on the Economy

Effects of Inflation on the Economy: Inflation is the sustained rise in prices of goods and services over time. This leads to the erosion of purchasing power. Purchasing power is the value of a currency expressed in terms of the number of goods and services that can be bought by one unit of the currency.

During periods of rising prices, uneven inflation acts like a hidden tax, hitting certain groups disproportionately. This loss of buying power, particularly for those already struggling, is the most concerning consequence of inflation.

In this article, we will read about Inflation and mainly the effects of inflation on the economy. We will also discuss the types and causes of inflation.

What is Inflation?

Inflation is the rate of increase in prices over a given period. It represents how much more expensive a set of goods or services has become over some time (most commonly a year). Inflation is typically a broad measure. For example, the overall increase in the prices or the increase in the cost of living in the country. But it can also be calculated as a narrow measure such as the increase in the price of a particular good or service.

Read More: List of Countries by Inflation Rate 2023

Types of Inflation

Inflation can be broadly divided into three categories depending on its range of increase:

• Low Inflation is inflation which is slow and predictable. It is gradual and takes place over a longer period.
• Galloping Inflation is very high inflation. It usually runs into double-digit numbers.
• Hyperinflation is a large and accelerating form of inflation. In this kind of inflation, not only do the prices shoot up very high, but they do so in a very short period.

Causes of Inflation

When prices rise, consumers lose purchasing power. An inflation rate of 2% to 3% is good for the economy but higher rates of inflation are very bad for the consumers and the economy as a whole.

The most common causes of inflation are:

• An imbalance in supply and demand. Inflation tends to increase when consumer demand for goods and services increases but the supply side is unable to meet this demand. This is known as demand-pull inflation.
• An increase in factor input costs (cost of land, labour, capital) pushes up prices. The price rise which is the result of an increase in the input costs leads to inflation. This is known as cost-push inflation.

Effects of Inflation on the Economy

There are multi-dimensional effects of inflation on an economy. This can be seen both at the macro and the micro levels. It redistributes income, destabilises employment, tax, saving and investment policies and it may result in recession.

• Inflation erodes purchasing power. An overall rise in prices over time reduces the purchasing power of consumers. This is because the number of goods and services that can be bought by the same unit of currency decreases as inflation increases.
• Inflation redistributes wealth from creditors to debtors. The lenders suffer and borrowers benefit from inflation because inflation allows borrowers to pay lenders back with money of lesser value than borrowed.
• Inflation results in higher interest rates. This is because the central bank tries to control inflation by increasing the interest rates. As the interest rates increase, borrowing money becomes expensive.
• Investment in the economy is boosted by inflation because higher inflation indicates higher demand suggesting expansion in production level by entrepreneurs. Also higher inflation results in lower costs of loans.
• Inflation feeds on itself when high and leads to a wage-price spiral. When inflation starts increasing above a certain level, the expectations of future inflation also rise. In this scenario, workers demand higher wages and employers offset their expenditure by increasing the prices of goods and services.
• In the short term, higher inflation results in an increase in the rate of savings provided by banks. But in the long run, higher inflation depletes the savings rate in an economy.
• With increase in inflation the currency of the nation depreciates because the buying power of the currency decreases. Foreign goods and services become more attractive to consumers and businesses as they are cheaper. This causes an increase in the currency supply in the forex markets and results in depreciation of the currency.
• Inflation leads to a drop in unemployment. But in the long run, higher inflation leads to a rise in unemployment. For example, during the 1960s in the USA unemployment dropped from 5.5% to 3.5% and inflation increased from 1.7% to 5.5%. But by the beginning of the 1980s the USA faced recession and inflation rates also increased. If the vicious cycle of inflation and unemployment continues, it can also result in recession. If the market is not ready for a hike in interest rates, it can result in lower economic growth. When this happens for one quarter, it is called contraction. But if this happens for two quarters in a row, then this indicates the start of recession.
• In the case of a developed economy, inflation makes trade balance favourable. For developing economies, however, inflation is unfavourable for the balance of trade due to their composition of foreign trade. The benefit to export which inflation brings into a developing economy is lower than the loss the economy incurs due to its imports. The imports become costlier due to inflation.
• Inflation makes taxpayers suffer while paying their direct and indirect taxes. Indirect taxes are imposed ad valorem (on value). Thereby increased price of goods increases indirect taxes. Direct tax burden of taxpayers also increases with increase in the gross income of taxpayers.

Effects of Inflation on the Indian Economy

Inflation rate is one of the important economic indicators for a developing economy like India. High inflation rates have a significant impact on the Indian economy.

Some of the effects of inflation on the Indian economy are:

• Grocery Bills Go Up: Imagine paying more for food and basic needs, leaving less for other things.
• Exports Get Pricier: Indian goods become less attractive overseas, making it harder to sell them abroad.
• Businesses Struggle: Higher costs eat into profits, slowing down the economy.
• Loans Get Expensive: Borrowing money becomes more costly, affecting everything from homes to starting businesses.

Conclusion – Effects of Inflation on the Economy

Inflation is good in moderation but largely has a negative impact on the economy. A low level of 2%-3% inflation is good for the economy but anything higher becomes detrimental. High inflation tends to feed on itself and this results in even higher inflation. It diminishes the purchasing power of the economy and depreciates the currency of the nation.

People Also Read:

• What is Hyperinflation? Causes, Effects with Examples
• What is Inflation? – Definition, Causes, Examples
• How Do Governments Fight Inflation?

FAQs on Effects of Inflation on the Economy

What is Inflation?

Inflation is the rate of increase in prices over a given period of time. It represents how much more expensive a set of goods or services has become over a period of time (most commonly a year). Inflation is typically a broad measure. For example, the overall increase in the prices or the increase in the cost of living in the country.

What are the effects of Inflation?

There are multi-dimensional effects of inflation on an economy. This can be seen both at the macro and the micro levels. It redistributes income, destabilises employment, tax, saving and investment policies and it may result in recession.

What are the types of Inflation?

Inflation can be broadly divided into three categories depending on its range of increase- Low inflation (which is slow and predictable), Galloping inflation (which is very high inflation running into double digit numbers) and Hyperinflation (which is a large and accelerating form of inflation in a very short span of time).

What causes Inflation?

The most common causes of inflation are an imbalance in supply and demand. Inflation tends to increase when consumer demand for goods and services increase but the supply side is unable to meet this demand. This is known as demand pull inflation.

What overall effect does Inflation have on the economy?

A particular level of inflation is healthy for an economy. This specific level is called the range of inflation. Inflation beyond the limits of this range is unhealthy for an economy. This can lead to contraction of the economy which will finally result in recession.