10 EFFECTS OF INFLATION

J.O. EMMANUEL

Inflation may be defined as a sustained rise in the money prices of goods and services in the economy.

There are several effects of inflation and we will look at each one of them in this post.

1. Inflation redistributes real income and wealth arbitrarily: When the inflation rate increases, the purchasing power of the currency decreases.

The decrease in purchasing power negatively affects people who hold cash or other liquid assets as the value of their assets declines in real terms.

However, those who hold tangible assets such as real estate, stocks, or precious metals, are less affected by inflation, as the prices of these assets typically rise in line with inflation or even faster than the inflation rate.

Therefore, inflation redistributes real income and wealth arbitrarily, as it imposes a tax on those who hold money in cash or liquid assets while favouring those who hold real assets.

2. Effect on fixed-income earners: When the inflation rate increases, the purchasing power of money decreases and the cost of living increases.

Because the income of those on fixed incomes does not increase correspondingly, they are unable to buy as much as they used to with the same amount of money.

Hence, inflation affects the standard of living of individuals with fixed incomes.

3. Effects on debtors and creditors: Inflation significantly affects borrowing and lending in the economy.

It affects the stability upon which all lending and borrowing depend on. 

Inflation generally favours the debtor because it reduces the value of money, which means that the amount of money owed by the debtor decreases in real terms.

On the other hand, inflation negatively affects creditors because it erodes the purchasing power of money over time, which means that the value of the money lent by a creditor decreases in real terms.

Therefore, Inflation benefits debtors and penalizes lenders or creditors.

4. It increases interest rate: Inflation affects the interest rate at which people lend and borrow money.

Inflation decreases the value of money, which means people and institutions would require a large amount of money to compensate for the decrease in the value of the money they lend.

The result is that the general interest rate increases as borrowers must now pay higher interest rates in order to get access to the funds they need.

The downside of higher interest rates is it discourages investment, as it makes it more expensive for businesses to borrow money to finance their operations and expansion.

5. Inflation discourages savings: When there is an increase in inflation, the value of money decreases and people are discouraged from saving.

This is because if someone saves money, they will be able to buy fewer goods and services in the future than they could have bought with the same amount of money in the present.

For example, let's say that a person wants to buy a pair of shoes that costs N1,000 today. 

If the inflation rate is 3%, the same pair of shoes will cost N1,030 next year. 

If the person saves N1,000 for the pair of shoes but doesn't buy it until next year, he will have to spend N30 more than he would have if he had bought it today. 

This is because inflation has caused the price of the pair of shoes to increase.

Therefore, Inflation makes people reluctant to save their money because inflation decreases the value of their money over time.

6. Generates industrial and social unrest: Inflation results in industrial and social unrest as workers and business owners compete for higher incomes.

Inflations make workers demand for annual wage increases to keep up with the rising cost of living and these put pressure on businesses to either increase their prices or sell at the same time but suffer reduced profit.

This can result in industrial unrest, especially if the employers are not willing to increase the wages of the employees, even though the cost of living has gone up.

In addition to industrial unrest, inflation may also result in social unrest among other groups in society. 

For example, retirees living on fixed incomes may see their purchasing power eroded by inflation, leading to protests and demands for government action. 

Similarly, businesses protests and demand relief or support from the government if their incomes are significantly affected.

7. Menu costs: The menu costs of inflation refer to the additional administrative costs that businesses incur in changing prices due to inflation.

When the inflation rate is rising, the price of goods and services is generally rising and businesses must adjust their prices to keep up with the rising costs of inputs such as labour and raw materials.

However, changing prices is not as simple as updating a menu or a price list. 

It requires a significant amount of administrative work, which involves renegotiating contracts with suppliers and customers, revising price lists and labels, and updating inventory systems.

This administrative work incurs additional costs, which are referred to as menu costs.

Therefore, inflation creates menu costs as businesses must incur additional administrative costs.

8. Shoe-leather costs: Reduction in the value of money creates an incentive for individuals to minimize the amount of cash they hold, thus resulting in more frequent bank trips and transactions.

These increased trips and transactions are known as shoe-leather costs of inflation.

9. Inflation decreases export and increases import: Export is the foreign demand for a country's goods while import is the local demand for foreign goods.

When inflation occurs, the prices of goods and services in a country increase so that the goods produced in that country become more expensive compared to goods produced in other countries.

As a result, the export of a country decreases so that firms exporting a large proportion of their output may have to lay off workers.

On the other hand, inflation increases imports because inflation makes foreign goods relatively cheaper in the local market 

Inflation makes a country's goods expensive in foreign markets, thus reducing the exports of the country.

On the other hand, inflation tends to increase imports because foreign goods become relatively cheaper in the local market, thereby increasing imports of goods and services.

Because it tends to increase imports and decrease export, Inflation can potentially lead to increases in trade deficits.

10. Effect of inflation on the foreign exchange rate: When the inflation rate in a country is high, the value of its currency in relation to other currencies tends to decrease. 

This is because investors and traders are less likely to hold onto that currency due to its decreased purchasing power.

Hence, inflation decreases the value of a country's currency in relation to other currencies.

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