10 Major Effects of Inflation and Deflation on Economy

Read this article to learn about the ten major effects of inflation and deflation on different sectors of the economy, i.e., (1) Effects on Production, (2) Effects on Distribution, (3) Debtors and Creditors, (4) The Entrepreneurs, (5) Investors, (6) Farmers, (7) Wage Earners, (8) Middle Class and Salaried Persons, (9) Government, and (10) Public Moral.

1. Effects on Production:

Keynes felt that as long as there were unemployed resources in the economy a moderate or a mild dose of inflation might be in order; because this would lead to waves of optimism inducing businessmen to invest more.

But this cannot go on forever because the limit is set by full employment ceiling, after which the prices start rising and moderate inflation starts assuming the nature of hyper-inflation which, in turn, has disastrous consequences on production.

It distorts the smooth functioning of price mechanism, hinders capital formation, stimulates speculative activities and hoarding, leads to misallocation of productive resources.

In short, inflation invites business to seek profits via manipulation of markets rather than via efficient production.

2. Effects on Distribution:

Inflation has the effect of redistributing income because prices of all factors do not rise in the same proportion. Entrepreneurs stand to gain more than wage earners or fixed income groups. Speculators, hoarders, black marketers and smugglers stand to gain on account of windfall profits.

Changes in the value of money also result in the redistribution of wealth partly because during inflation there is no uniform rise in prices and partly because debts are expressed in terms of money. Inflation is a kind of hidden tax, steeply regressive in character and in effects. This redistribution of wealth as a result of inflation puts more burden on those groups of the economy which are least able to bear it.

3. Debtors and Creditors:

Debtors borrow from creditors to pay the latter along with the rate of interest at some future date. Changes in the price level affect them differently at different times. During inflation when the prices rise (and the real value of money goes down), the debtors pay back less in real terms than what they had borrowed, and thus, to that extent they are gainers. On the other hand, the creditors get less in terms of goods and services than what they had lent and stand to lose to that extent. During the period of deflation, however, when prices fall (and the real value of money rises), creditors stand to gain and debtors lose.

4. The Entrepreneurs:

When prices rise, producers, traders speculators and entrepreneurs stand to gain on account of windfall profits because prices rise at a faster rate than cost of production, besides, there is time-lag between the two. Moreover, they gain because the prices of their inventories (stock) go up.

Again, they generally being borrowers of money for business purposes, stand to gain. On the other hand, falling prices heavily reduce the profits on account of the fact that wages fail to fall along with the fall in the prices. Entrepreneurs, therefore, react to it by curtailing the volume of production and hence employment goes down generating a full-fledged depression.

5. Investors:

Different kinds of investors are affected differently by inflation and deflation. One can invest in bonds and debentures which yield a fixed rate of interest income or one can invest in real estate or equities (shares) whose returns (dividends) rise and fall with profits earned by the companies concerned. When prices rise, the returns on equities go up on account of the rise in profits, while the bonds and debenture-holders gain nothing as their incomes remain fixed.

On the other hand, equity-holders will lose during depression on account of a fall in the price level, while the debenture- and bond-holders gain. To the extent investors are able to diversify their investment, they can protect themselves from the effects of the fluctuation in prices.

6. Farmers:

Farmers gain during inflation. The prices of farm products go up and the cost incurred by them (like interest and taxes) either remain constant or do not increase much, at any rate i.e., costs lag behind prices received by the farmers. In India, during war and post-war period, farmers were able to pay-off their old debts on account of high prices of their products because of inflation. Moreover, farmers are generally debtors and have to pay less in real terms, while the land revenue and taxes etc., do not rise much. Thus, farmers stand to gain during periods of inflation.

7. Wage Earners:

Wage-earners generally suffer during inflation, despite the fact that they obtain a wage rise according to a rise in the cost of living index. However, wages do not rise as much as the rise in prices of those commodities, which the workers consume. Further, there is a lag between a rise in the price level and a rise in wages. If the workers are organized, they may not suffer much during inflation but if they are unorganized like the agricultural labourers, they may suffer more, as they may not find it easy to get their wages increased. Similarly, in deflation the real value of the money wages received by them increases and they may gain a little.

8. Middle Class and Salaried Persons:

The hardest hit are the persons who receive fixed incomes, usually called the middle class. Persons who live on past savings, fixed interest or rent, pensioners, government employees, teachers etc., suffer during periods of rising prices as their incomes remain fixed. Kemmerer remarked: “The middle class, however, which by hard work and thrift has built up a fund of saving to educate its children and to provide a livelihood for times of sickness and for old age, finds itself in a desperate situation in a time of serious inflation.” During deflation, however, middle class is able to get some relief on account of falling prices and rising value of money.

9. Government:

In a mixed economy, the public sector is affected by fluctuations in price level. As prices rise, the government has to spend more on goods and services including raw materials for carrying through their project. Estimates are revised and taxes are raised. On the other hand, when prices fall, the government sector or the public sector has to incur less costs.

10. Public Moral:

Inflation results in arbitrary redistribution of wealth favoring businessmen and debtors and hurting consumers, creditors, petty shopkeepers, small investors and fixed income earners. This lowers the public moral. The ethical standards and the public moral had fallen to miserably low levels during the period of hyper-inflation in Germany.