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Effects of Inflation - The Positives and the Negatives

Updated on May 29, 2013

Definition

Before going more in depth about the positives and negatives of inflation, the term "inflation" must be defined.rice of products goes up, jet people are still buying them.

There are two major types of inflation; core inflation and inflation in the broader sense. Core inflation is a measure of average. In this case a very carefully selected group of goods' (in economics it is called "basket of goods") change in consumer price over a period of time is observed, and then those consumer prices are averaged. Consumer prices are simply that people pay for the product (there is also an industrial price and inflation measuring supplier price changes). The most widely used periods over which inflation is measured are: 1 month, quarterly, semi-annual, and annual. Core inflation means only the very basic products's prices are monitored, such as bread for example. When there is a high inflation, its an indicator that the economy is booming, as the price of products goes up, jet people are still buying them.

Probably the most significant effect of inflation is its effect on the revenues of the government. When inflation is higher than previously thought and planned with, the revenues of the government increases, which is good as the budget balance of the government improves. The reason why revenues of the government increases when inflation incrases is because the government has higher tax revenues. For example a company sells its products and services at higher prices, which increases the total income of the company, which in turn increases the gross (before tax) profits of the company (provided that all other factors influencing profits remain constant). Greater before tax profits result in greater taxes paid to the government.

Inflation also slows the economy, thus serving as a natural economy balancer, as well as a crucial indicator. The reason why growing inflation moderates economic growth, and also potential overheating of the economy, is because, when prices increase and increase people, as well as companies from their suppliers, start to buy less and less. This function of inflation decreases the needs of central bank base rates' hikes, which in itself has many negative side effects (like increasing the interest payment obligations of governments).

Most of the times inflation and exchange rate of the currency of a country move more or less parallel. This means that if inflation increases, and the official statistical office of a country publishes the figures of the speeding up of inflation, the exchange rate of the currency of the country against foreign currency is also expected to, and in reality it really does more often than not, devalue. The reason why exchange rates are so important is because they affect the competitiveness of exporting companies of a company. The importance of exporting lies in the arrival of new money into the economy of a country. For example, if a country has, say, 100 billion dollars of national economic output, 1 billion more means that companies have 1 billion more to spend in the country, and also the government has more tax income which it can spend on spending more on social matters. This means that inflation, in this aspect also, is a significant indicator.

Inflation, on the other hand, can also be quite destructive. For example, a slow in inflation make importers' products cheaper, whereas domestic manufacturers' product prices remain the same. A sudden slow in inflation causes lower imported product prices, meaning two things. First, because of the lower import prices, more people will by imports opposed to domestically manufactured products. This hurts domestic production, which in turn may result in rising unemployment (domestic producers fire employees to keep up with shrinking sales revenue)

Another problem with rising inflation arises when inflation starts to increase excessively. For example, when inflation surpasses 10 percent, that has two effects. People will start spending more, hurting companies, especially those companies that are domestic companies and are selling their products domestically. Also the real value of savings of both people and organisations also decrease, having a negative effect on CDs (certificate of deposits), and other fixed rate investment instruments.

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    • profile image

      Jicell 

      6 years ago

      What is the most common effect of inflation?

    • profile image

      Julian 

      6 years ago

      there are no enough explanation so try to add some explanation to the answer and being in good arrangement

    • Csanad profile imageAUTHOR

      Csanad 

      8 years ago from Budapest, Hungary

      Check out Canadian Inflation from 1966 to 2004 here:

      http://www.bankofcanada.ca/en/ragan_paper/inflatio...

      Also check out the inflation rate and the Commercial bank discount rate here:

      https://www.cia.gov/library/publications/the-world...

      It seams that on the long run long term Canadian Treasury bonds are worth purchasing.

      In general inflation rate in Canada seems to be between 2 and 4 percent annually. I guess anything that offers about 4.5 percent annually is worth investing into in the long run.

    • Eric Deslauriers profile image

      Eric Deslauriers 

      8 years ago from Cambridge, Ontario

      In terms of 30 year investment horizons, what sort of overall annualized average can inflation be expected be? I want to figure out just how much I need my portfolio to gain in 30 years to keep my principle safe from the inflation..

    • Evan G Rogers profile image

      Evan G Rogers 

      8 years ago from Dublin, Ohio

      Hey there, well written article.

      I was a bit surprised that you didn't include a third definition of inflation: an increase in the money supply. This has been argued to be the real source of price inflation (which would be considered merely a symptom of the larger problem of an increased money supply).

      Normally, if production and supply increase over time, and the money supply stays constant, the prices in an economy should go down (a simply supply-demand chart shows this). This tends to show that the natural tendency of prices is to decrease - just look at the computer industry, and the price of food throughout history. But as the amount of money in an economy increases, the amount of money it takes to buy something increases, and thus so do prices.

      Well anyway, hope my opinions help!

    • Csanad profile imageAUTHOR

      Csanad 

      9 years ago from Budapest, Hungary

      I think that in the coming few years, like next five or so years, the world has to cope with high levels of inflation. there are 2 primary reasons for it, printing cash to finance all the debts created (bail outs), an as growth in the economy picks up, it will also create rising prices (which companies largely postponed last and this year). After these few years the level of inflation, in my oppinion, will stabilise at a high level for the following five years or so.

    • Kapitall profile image

      Kapitall 

      9 years ago from www.kapitall.com

      Do you think inflation in the next 10 years will continue to grow at a normal rate or exponential?

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