Impact of Inflation

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1. On Growth
  • There is a trade-off between Inflation and growth rate of economy, increase in rate of inflation leads to increase in growth rate and vice versa
  • RBI controls inflation through monetary policy tools
  • Sometimes measures taken to control inflation lead to decrease in growth rates making inflation control a highly complicated process.
2. On Quality of Life
  • Inflation reduces the purchasing power of money in the hands of households thus declining their quality of life.
  • Ex: Salary 15,000 – Spent 12,000 & save 3,000. But due to inflation price of goods increase. So, need to spent whole 15,000. Not have money to save.
3. On Creditors and Debtors
  • Fall in purchasing power of money will affect the creditors as the value of money is reduced during the maturity period of loan.
  • Inflation redistributes wealth from creditors to debtors, i.e., lenders suffer and borrowers benefit out of inflation. The opposite effect takes place when inflation falls (i.e., deflation).
  • Ex: Creditor give Rs. 100 loan (value to buy 10 tea), debtor return Rs. 105 (with interest) but, now creditor buy only 7 teas (Because tea rate increase due to Inflation).
4. Redistribution of wealth
  • From fixed income group to flexible income group as salary of flexible income group is adjusted to inflation but salary of fixed income group remains constant. Redistribution of wealth from Consumers to producers as the profit of producers tend to increase with inflation but purchasing power of money of consumer falls. Hence consumers pay more for the same commodity whereas producers gain more loan.
  • Ex: In 2021, 1000 car manufacture sell at 5 lakhs – 500 car sold. But, In 2022 due to inflation car price increase from 5 lakhs to 5.5 lakhs. So, the balance 500 car get more profit.
5. On Investment
Investment in the economy is boosted by the inflation (in the short-run) because of two reasons:
  • Higher inflation indicates higher demand and suggests entrepreneurs to invest more to expand their production levelto cater the demand, and
  • Higher the inflation, lower the cost of loan (Low interest rate).
  • Ex: Mask produce by all company.
6. On Savings
  • In encourages savings in bank in short run as holding money in hand reduces its purchasing power. Interest on the deposits offsets inflation to certain level.
  • But in long run, People tend to invest on inflation linked commodities like gold instead of savings in bank.
  • Ex: Saving on Piggy bank, Bank, Investment [Gold, Stocks & Mutual Funds]).
    • Piggy Bank: 2020 – 1000, 2022 – 1000. (Money value eroded).
    • Bank: 2020 – 1000, 2022 – 1030 (Interest). (Money value eroded).
    • Investment: Gold: 2020 – 3500, 2022 – 4500 (Inflation adjusted commodity), Stocks & Mutual funds (Adjust Based on Market).
7. On Tax
  • Tax-payers suffer while paying their direct and indirect taxes.
  • As indirect taxes are imposed ad valorem (on value), increased prices of goods make tax-payers to pay increased indirect taxes (like GST, vat, etc.,)
  • Similarly, due to inflation, direct tax (income tax, interest tax, etc.) burden of the tax-payers also increases as tax-payer’s gross income moves to the upward slabs of official tax brackets (but the real value of money does not increase due to inflation; in fact, it falls).
  • The extent to which tax collections of the government are concerned, inflation increases the nominal value of the gross tax revenue, while real value of the tax collection does not compare with the current pace of inflation as there is a lag (delay) in the tax collection in all economies.
  • Ex: Indirect tax: Product Rs. 100 + 10% tax = 100 + 10 = Rs. 110. Due to inflation, product Rs. 120 + 10% GST = 120+12 = Rs. 132.
  • Direct Tax: Income: 5,00,000 pay tax 15% = Rs. 15,000, Salary increase 6,00,000 pay same tax 15% = Rs. 18,000.
Inflation wage Spiral
8. On Exchange Rate
  • With every inflation the currency of the economy depreciates (loses its exchange value in front of a foreign currency) provided it follows the flexible currency regime.
Example
  • Export: When, 1$ = Rs. 75, Export 2kg tea at 2$ (Rs. 150). Due to inflation (1$ = Rs. 80). The exporter gets same 2$ but value in India is 160.
  • Import: farmer import 1kg seeds at 1$ (Rs. 75), but inflation rupee value eroded. so, 1$ =Rs.80. Now, farmer give Rs. 80 to Import Seeds.
Rupee WeakeningExport Income ↑ & Import became Costlier
Rupee StrengtheningImport Income ↑ & Exporter get low Income.
9. On Export
  • Cost push inflation discourages exports (Not certain)
  • But export income increases due to depreciation of currency as a result of inflation
10. On Import
  • Demand pull inflation encourages Imports. Governments encourage import to cater the demand and bring inflation under control (Not certain)
  • But imports become costlier due to depreciation of currency as a result of inflation 

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