Consequences of inflation
High inflation rate may result in the following adverse effects on the economy:
Greater uncertainty: There may be greater uncertainty for both firms and households. Firms will postpone their investment due to uncertainty in the market. This will result in negative implications on the economic growth in the economy.
Redistributive effects: High rate of inflation will affect people who have constant incomes, such as retired people, students, and dependents. Moreover, rise in prices of essential commodities (food & clothing) will affect the poor segment of the society as they spend a major part of their income on these good. This will lead to increased inequality in the economy.
Less saving: High rate of inflation will have an adverse effect on the savings in the economy. As people spend more to sustain their present standard of living, less is being saved. This will result in less loanable funds being available to firms for investment.
Damage to export competitiveness: High rate of inflation will hit hard the export industry in the economy. The cost of production will rise and the exports will become less competitive in the international market. Thus, inflation has an adverse effect on the balance of payments.
Social unrest: High rate of inflation leads to social unrest in the economy. There is increase dissatisfaction in among the workers as they demand higher wages to sustain their present living standard. Moreover, high rate of inflation leads to a general feeling of discomfort for the household as their purchasing power is consistently falling.
Interest rates: The Central Bank might use monetary tools to control high inflation rate by increasing interest rates. This will increase the cost of borrowing and will have a negative effect on both consumption and investment.
Shoe leather cost refers to the cost of time and effort (more specifically the opportunity cost of time and energy) that people spend trying to counter-act the effects of inflation, such as holding less cash and having to make additional trips to the bank.
Menu cost is the cost to a firm resulting from changing its prices
Consequences of deflation
Consistent fall in the general price level in the economy (deflation) might not be good news for the economy. Long term deflation will lead to:
Cyclical unemployment: Deflation usually happens to due to a fall in Aggregate Demand in the economy. This will lead to businesses cutting the output levels which will result in retrenchment/laying off of workers. Moreover, if consumers delay spending in anticipation of falling prices economic activity falls, unemployment increases.
Bankruptcies: As the value of money is increasing, it becomes difficult for debtors to repay the load. Moreover, during deflation firms will be having lower profits due to falling prices and will find it difficult to meet their liabilities. This might lead to greater number of bankruptcies. Businesses see profits fall; as they do so dividends and investment returns fall and so share prices fall.
Deflationary spiral: Consistent fall in prices may trigger deflationary spiral. As firms make less profit, this leads to less profits, they might not be willing or able to invest which will have negative implications on the economic growth. Moreover, as firms cut cost by lay off workers, there is less income for the households and the aggregate demand might fall. Due to a fall in consumer and business confidence the economy might fall into a deflationary spiral.
The principle problem of deflation is that it leads to a rise in the real value of debt. In the early stages low interest rates and low prices encourage borrowing but as the real weight of the borrowing is recognised so borrowing is reduced.
It is sometimes difficult to control deflation and Monetary policy can prove ineffective when interest rates (nominal) are already low.
