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Effects of Inflation

  1. On creditors and debtors 
    • Redistributes wealth from creditors to debtors 
    • Lenders suffer and borrowers benefit 
    • Opposite happens when inflation falls(deflation) 
      
  2. On lending 
    • Institutions feel the pressure of higher lending as real interest rate is less than nominal rate. 
  1. On aggregate demand 
    • Indicates comparatively lower supply and aggregate demand rises 
    • Higher purchasing power 
    • Suggests producers to increase production level 
  1. On investment 
    • It is boosted in the shorter run 
    • Suggests to expand production and hence investment 
    • Higher inflation, lower the cost of loan 
  1. On income 
    • For individuals and firms, nominal value of income increases, while real income remains the same 
    • In shorter run, the value erodes. In longer run the incomes go up due to inflationary situation and increased earning.  
  1. On saving 
    • Holding money is not an intelligent option. 
    • People put maximum in banks in savings accounts as savings rates increase. But this happens in short run. In longer run it depletes the value. 
  1. On expenditure 
    • Consumption falls as prices of goods and services increase 
    • Investment expenditure increases as borrowers get finances at ‘low cost’ 
  1. On tax 
    • Increased prices of goods and services means people need to pay more indirect taxes- ad valorem(on value) 
    • Direct taxes also increase as people move in to higher tax slabs( but real value is not increasing)- known as bracket creep 
    • Hence in the US and european countries tax provisions are indexed to inflation 
    • For the govt, tax revenue goes up but real value does not compare with the current pace of inflation as there is a lag in tax collection. 
    • However govt benefits on interest burden front as it is a huge borrower. 
  1. On exchange rate 
    • Loses value against a foreign currency- depreciation 
    • It is a comparative matter, as the foreign currency might be facing inflationary pressure. 
  1. On exports 
    • Exportable items have competitive prices in world market and volume of exports increase while their value decreases 
    • Hence export income increases 
    • Importing partners put pressure for stable exchange rates as imports increase 
  1. On imports 
    • Gives an advantage of lower imports and import-substitution as they are costlier. 
    • But in case of compulsory imports economy loses more foreign currency. 
  1. On trade balance 
    • Exporting countries (developed) stand to gain, while countries with compulsory  imports lose(developing) 
  1. On employment 
    • Philips curve and NAIRU 
  1. On wages 
    • Negative impact on purchasing power and living standards of wage earners 
    • DA for organised sector employees 
  1. On the economy as a whole 
    • All the above segments belong to an economy 
    • There is a range of  inflation which is thought to be healthy for every economy. Developed countries have the range of 1 to 3%, while for India 4-5% is seen as comfort zone. 
    • Inflation beyond range brings recessions and depressions. 
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