An increase in the general level of prices implies a decrease in the real value of money. That is, when the General level of prices rises, each monetary unit buys fewer goods and services. Many people are willing to accept inflation if it can provide full employment because then it is a small price to pay. But we should not underestimate the socially unacceptable effects of inflation. It is true that unemployment is an economic as well as a social evil but this should not blinds to the evils of inflation. We explain below now inflation affects the economic, social, political and moral life of the people.
In general, high or unpredictable inflation rates are regarded as bad for following reasons:
Uncertainty about future inflation may discourage investment and saving.
Inflation redistributes income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and current profits which may keep pace with inflation. The real value of retained profits is destroyed at the rate of inflation as the historical cost balances stay fixed like pensioners fixed income. However, debtors may be helped by inflation due to reduction of the real value of debt burden
- International Trade:
Where fixed exchange rates are imposed, higher inflation than in trading partners economies will make exports more expensive and tend toward a weakening balance of trade. A sustained higher level of inflation than in the trading partners economies will also, over the long-run, put upward pressure on the implicit exchange rate making the fix unsustainable and potentially inviting an exchange rate crisis.
- Cost-push inflation:
Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations. This will be higher when inflation has an upward trend. This can cause a wage spiral. In a sense, inflation begets further inflationary expectations.
People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects.
In inflation gets totally out of control, it can grossly interfere with the normal working of the economy, hurting its ability to supply.
Some possibly positive effects of inflation include:
Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high and high unemployment in the labors market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesian argue that some inflation is good for the economy. As it would allow labour markets to reach equilibrium faster.
The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank’s interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further in order to stimulate the economy-this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates rather than the money supply in determining inflation.
A fundamental concept in inflation analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off between price stability and employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment.