Inflation has a major effect on production, and on distribution of income and wealth. The effects of inflation on various aspects of the economy are explained below:
Effect on Production
Inflation encourages production since, producers can anticipate greater wind fall gains in the future. They invest more at present to get better returns in the future. This further encourages employment, and income as well. However, after the economy reaches full employment, after which further production is not possible, only prices rise and creates a negative impact on production.
Effect on inflation on production can be further classified as follows:
Reduction in output
The rise in prices along with rise in costs of production brings uncertainty to the producers. So, they reduce their output. However, this occurs only due to cost push inflation, whereas, a demand pull inflation has a reverse effect on production.
Mis-allocation of resources
When inflation occurs, producers are involved in production of goods that provide higher profit. So, resources are allocated for goods with higher profit margin rather than essential goods.
Black marketing and hoarding of resources
With an intention of earning more profit, producers hoard the stock of products, causing artificial scarcity in the economy. They then sell their products at higher prices in the black market.
Fall in quality
Since prices for goods are rising, producers are involved in the manufacturing and selling of low quality goods and services. Immoral activities like adulteration of goods also take place in the economy.
Effect on distribution of Income and Wealth
The effect of inflation is different for different groups of income earners. Generally, inflation has a greater impact on those groups with fixed level of income such as workers, pensioners, etc. rather than on traders and businessmen. The impact of inflation on middle and low income group (workers, salaried people) also depends on labor market conditions. If the labor market adjusts payable salary according to rise in price, inflation has less effect and vice versa.
The effect of inflation on various groups of income earners can be further explained as follows:
The effect of inflation on people who work on wage basis depends on how their wages are adjusted to rising prices. If the existing trade union is working on a contract basis where wage rates are fixed for a certain duration of time, workers suffer as they do not get paid more even when the price of commodities are increasing.
White collar workers such as teachers have difficulty adjusting their salary with the rising prices. Since, their salary do not increase in proportion to the rising prices, they suffer during inflation.
Debtors and Creditors
Inflation works in favor of debtors since value of money falls when prices rise. And as a result of this, they pay less in terms of goods and services when they pay off their debt. Thus, the burden of debt decreases and they gain. On the other hand, creditors are at loss due to inflation. This is because value of money falls during inflation, so even when they get back the same amount, they receive less in real terms.
Businessmen such as producers, traders, and real estate agents gain during inflation. Producers profit because they can sell commodities at higher prices with no immediate rise in their cost of production (wage, rent, etc.). Real estate agents also gain more because during inflation, the price of land increases faster than other goods and services.
Equity holders and investors
Shareholders earn while investors of bonds, securities are at loss during inflation. When prices rise, business firms earn more profit and give out more dividend to shareholders. But, bond and security holders gain only on fixed interest rate. So, they receive a fixed sum while the value of money is decreasing due to rise in price level.
Besides the above mentioned effect of inflation on production, and distribution of income, there other aspects affected by it. Inflation gives rise to uncertainty in the economy and disrupts the price mechanisms that helps in smooth functioning. Along with this, it creates an illusion of prosperity within a nation as it leads to rise in wages and profit. It may also cause the monetary system to fall if the existing inflation rate keeps growing to reach hyperinflation.
Along with monetary problems, inflation also affects the social and political aspects of an economy or a country by creating discontentment among individuals and household sectors.