The increase in prices of goods and services over an extended period is called inflation. It occurs due to the undervaluation or reduction in the value of a currency. A high inflation rate means that the prices of goods, commodities, and services in an economy have increased suddenly to a high extent. If the increase in prices is not matched by the increase in the income levels of ordinary people, the purchasing power of people will reduce. Therefore, inflation can be a cause of a slow or stagnant economy.
Inflation can also show and reveal the strength of the Dollar at a particular moment and how powerful it is when it comes to purchasing the products and services being sold in an economy. Inflation is the rate at which the average prices of a basket of commonly sold products increase over a period. Inflation may often be expressed in the form of percentages and will denote the decrease in the purchasing power or capacity of the currency of a nation.
The Cause of Inflation
A common cause of inflation can be a rapid increase in demand that cannot be matched and fulfilled by the current production capacity. It is also termed “demand pull” inflation. For instance, if the Central Bank of a country starts to print more money and increases the money supply in an economy, it may result in excessive demand.
It is common knowledge that a country should not have excessive debt and should not borrow excessively from world banks (such as the International Monetary Fund) and other countries. An increase in national debt may also be a cause of inflation and result in a slow or stagnant economy. When a country accumulates excessive national debt, it may try to overcome it by printing more money or by raising taxes. If the government starts to apply more taxes on businesses, the businesses will also increase the prices of the services or goods they are offering to the market and the consumers. It will again be a cause of inflation.
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Also occurs due to reasons not related to the demand for products in an economy. Increased exposure to foreign currencies and marketplaces may also increase volatility and cause a worsening of inflation in a country. Inflation may also occur due to the ‘cost-push” effect. The theory states that when business organizations must spend more money on acquiring raw materials and human resources (among other business inputs) they will try to remain profitable by increasing the cost of the products/services that they offer/sell. Lastly, inflation may also occur as is often anticipated, and people expect that the prices will rise.
Effects of Inflation on an Economy
A rise in prices may have effects on the cost of conducting business activities, cost of living, mortgage, borrowing, and the yields of the Government and corporate bonds, among other elements and facets of an economy. The current rate of inflation may be measured based on the “consumer price index” and other metrics. The effects of inflation on the economy of a nation can be positive as well as negative.
The Favorable or Positive Effects of Inflation on the Economy
The favorable impacts and consequences of inflation are discussed briefly below.
- Higher profits: when the economy is affected by inflation, the producers can sell their offerings at a higher rate and price, which results in higher profits.
- Better returns: the entrepreneurs and the investors make greater incentives when they invest and make efforts in production and business activities during inflation. They may also receive better income and returns due to it.
- Higher production: inflation may also result in a greater production of the products in the economy when the production producer can obtain investment.
- Increase in employment: greater demand for products/services will require greater production. Companies will hire more people to fulfill their business objectives, which will increase the employment rate. The income of an economy may also increase due to inflation.
- Better returns for shareholders: shareholders may also generate more income and better returns due to their stock holdings following inflation. Many companies may distribute dividends to their stockholders as they can earn more profits during times of inflation.
- Benefits for the debtors and borrowers: the purchasing power of a currency will reduce during inflation, as it will become undervalued. If a borrower/debtor of a loan is paying back the loan at a rate of interest that is less than the rate of inflation, the borrowers will gain. The real value of money will decrease during inflation.
The Unfavorable or Negative Effects of Inflation
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The unfavorable or negative effects of inflation on an economy and its different facets are discussed briefly below.
- A fall in income for people living on a fixed income: the true income or money that a person earns and receives during a period depends on the value of that money or currency during that period. People, including salaried individuals and pensioners, who live on a fixed income every month will lose during inflation. When the currency devaluates, their purchasing power will reduce.
- Inequality: business owners, entrepreneurs, and corporates can earn high profits during inflation. However, people from other income groups (including those with fixed income) will witness a reduction in their real purchasing power and income. Therefore, inflation will be a cause of inequality in an economy.
- Bad for national planning: governments often devise and implement multi-year development plans. However, inflation increases the price of raw materials, goods, and services. When it occurs, a government may have to increase its expenditure to fulfill its objectives. Governments may increase the taxes or assess the savings for this purpose.
- Speculation: inflation may also be the cause of speculative investments. People are not sure how much the prices will rise in the coming times and therefore start to speculate. People may start to invest in stocks, land, and in other areas for making the most profits in the least time. Such investments are unwise and do not result in long-term sustainability or healthy productivity.
- Loss for the lenders: while the debtors and borrowers can benefit due to inflation, it may be a cause for loss for the lending banks and other financial institutions. The repayment that they will receive during inflation has less purchasing power and value.
Inflation can have both good and bad effects on an economy. Knowing the effects of inflation on an economy and its different facets can help you make wise and fruitful investments that can bring you handsome returns. Investing in stocks should be based on research and should not be speculative. The more knowledge you have, the better investments you can make.