Question

What are the causes and effects of inflation on the economy?

Answer 1

The main causes of inflation in India are as follows:

1. Increase in Money Supply: Inflation is caused by an increase in the supply of money which leads to an increase in aggregate demand. The higher the growth rate of the nominal money supply, the higher is the rate of inflation.
2. Increase in Disposable Income: When the disposable income of the people increases, it raises their demand for goods and services. Disposable income may increase with the rise in national income or reduction in taxes or reduction in the saving of the people.
3. Increase in Public Expenditure: Government activities have been expanding due to developmental activities and social welfare programmes. This is also a cause for price rise.
4. Increase in Consumer Spending: The demand for goods and services increases when they are given credit to buy goods on a hire-purchase and installment basis.
5. Cheap Monetary Policy: Cheap monetary policy or the policy of credit expansion also leads to an increase in the money supply which raises the demand for goods and services in the economy.
6. Deficit Financing: In order to meet its mounting expenses, the government resorts to deficit financing by borrowing from the public and even by printing more notes.
7. Black Assets, Activities, and Money: The existence of black money and black assets due to corruption, tax evasion, etc., increases the aggregate demand. People spend a lot of money, lavishly. Black marketing and hoarding reduce the supply of goods.
8. Repayment of Public Debt: Whenever the government repays its past internal debt to the public, it leads to an increase in the money supply with the public.
9. Increase in Exports: When exports are encouraged, the domestic supply of goods declines. So prices rise.

The effects of inflation can be classified into two heads:

1. Effects on Production and
2. Effects on Distribution.

1. Effects on Production:
When inflation is very moderate, it acts as an incentive to traders and producers. This is particularly prior to full employment when resources are not fully utilized. The profit due to rising prices encourages and induces business class to increase their investments in production, leading to the generation of employment and income.

1. However, hyperinflation results in a serious depreciation of the value of money.
2. When the value of money undergoes considerable depreciation, this may even drain out the foreign capital already invested in the country.
3. With reduced capital accumulation, the investment will suffer a serious setback which may have an adverse effect on the volume of production in the country.
4. Inflation also leads to hoarding of essential goods both by the traders as well as the consumers and thus leading to a still higher inflation rate.
5. (V) Inflation encourages investment in speculative activities rather than productive purposes.

2. Effects on Distribution:

1. Debtors and Creditors:
   During inflation, debtors are the gainers while the creditors are losers.
2. Fixed – income Groups:
   The fixed income groups are the worst hit during inflation because their incomes being fixed do not bear any relationship with the rising cost of living.
3. Entrepreneurs:
   Inflation is a boon to the entrepreneurs whether they are manufacturers, traders, merchants, or businessmen because it serves as a tonic for business enterprise.
4. Investors:
   The investors, who generally invest in fixed interest yielding bonds and securities have much to lose during inflation.