The following points highlight the four main effects of inflation on rising of prices.
Effect # 1. Inflation and Income:
As noted earlier, unemployment intensifies the scarcity problem by reducing or even terminating the incomes of some people. Inflation also reduces income—not in the same way as unemployment, but by reducing the purchasing power of money.
When inflation sets in, a given amount of money, or nominal income —income measured in terms of current dollars —buys fewer goods and services. Expressed differently, real income — or income measured in terms of the goods and services that a particular amount of money income can purchase — falls. Consequently, the scarcity problem for households and individuals is aggravated when money incomes do not rise as rapidly as prices.
Redistribution of income:
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(a) Unionised vs. non-unionised workers:
As different groups of people differ in their ability to protect themselves from the effects of inflation, there will be a redistribution of income from those least able to protect themselves towards those better able to undertake such protection.
Workers belonging to strong trade unions may be able to use the strike weapon (or the threat of using it) to secure wage increases which at least keep up with the rate of inflation, thereby protecting the real value of their wages and earnings. On the other hand, workers who are less well-organised will find it more difficult to maintain their real wages.
(b) Fixed vs. variable income groups:
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People on fixed incomes suffer during inflation. The salaried people, pensioners, rentier class (landlords) and holders of Government bonds (or even debenture-holders) lose during inflation. They become progressively worse off as price rises. Those who live on government pensions may be given increases from time to time to offset the increase in the cost of living (as in Britain), but all who live on fixed incomes suffer a decline in real income during inflation.
(c) Lenders and borrowers:
Another element of redistribution which may take place is that between borrowers and lenders. If the rate of inflation is expected to be, for example, 5%, a person lending Rs. 100 to someone for a year might require a rate of interest of, say 7%, i.e., a real interest rate of 2%. If, however, the inflation rate rises to 10%, the real rate of interest will be 3%. In this case the borrower has gained and the creditor has lost, i.e., there is a redistribution of income from creditor to borrower.
In general, all debtors gain and all creditors lose during a period of inflation. Those who save may by penalised by inflation if the interest rate they receive is less than the rate of inflation.
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Those who make loans may also be hurt by inflation if the interest rate they charge is less than the rate of inflation, and if the terms of the loans are fixed and cannot be altered to allow interest rate increases. This type of problem often emerges when a lender makes a long-term loan commitment.
In evaluating how inflation affects savers and borrowers, the real rate of interest must be considered. The real rate of interest is the nominal, or stated, interest rate minus the inflation rate. For example, if the nominal interest rate on a certificate of deposit is 6% and the inflation rate is 8%, the real rate of’ interest earned by the certificate holder is – 2% percent. In this case, the saver is hurt by inflation. If the inflation rate is 3% during the term of a 6% of deposit, the real rate of interest is 3%. In this case, the saver has gained by saving.
Effect # 2. Income and Wealth:
Income and wealth are two different measures of economic well-being. Income represents a flow of funds, or earnings, from selling factors of production; wealth is a measure of the stock, or value, of one’s tangible assets, or a measure of what one owns. It includes such items as stocks, bonds, real estate, cash, precious metals and stones, and fine art objects. A person could have a substantial income and little wealth, or great wealth and a small income.
Effect # 3. The Burden of Public Debt:
The burden of the National Debt is decreased because a smaller proportion of the national income has to be raised by taxation in order to pay the interest charges to lenders. The real cost of paying the interest falls. This occurs because; as incomes increase so do the proceeds from taxation, whereas the interest charges on the national debt remain the same.
During inflation, the value of many assets tends to increase as prices rise. Thus, the wealthy become wealthier. Consider real estate. A home valued at Rs. 50,000 in 1980 might well be worth Rs. 150,000 today largely as a result of inflation.
While inflation benefits the holders of wealth, it penalizes those wanting to acquire assets. Again, consider real estate. As prices rapidly increase, those wanting to purchase a home find it more difficult. In this sense, young adults pay a higher penalty than others for inflation as it becomes more difficult for them to accumulate assets.
Effect # 4. The Balance of Payments:
If the rate of inflation is higher in India than elsewhere, then this makes Indian goods less competitive both within and outside the country. Other countries will note the higher prices of Indian exports and will reduce their demand accordingly. Furthermore, people inside India will find that imported goods are now relatively cheaper and will adjust their purchases to take account of this. Thus, the demand for India’s exports will fall and the demand for imports into India will rise.
There is, therefore, an unfavourable effect on the current account of India’s balance of payments. It is this effect which has often prompted action from the government to deal with inflation. (We should note that this effect may be offset by a compensating change in the exchange rate of the rupee.)