Inflation is known to affect the economic climate of a country. This could be short-term or long-term, depending on the level of intervention and other economic forces. If not properly dealt with, it could undermine the economic growth of a country.
Role of inflation
Inflation has often been described or defined in terms of its resultant effect which is always a general as well as a sustained increase in prices. It interferes with flooring and sealing, thus making it difficult to control price levels. It also creates deficits in the balance of payment, which may lead to the devaluation of the local currency. Devaluation of the local currency also affects the exchange rates for exporters. Inflation lowers the competitiveness of the domestic market about the global market. This means that it destabilizes the economy especially in the sectors of production and consumption, which in turn creates an imbalance in the supply and demand in the economy.
Definition of inflation
The ultimate results of inflation give it its definition. Inflation means an increase in the general level of prices of services as well as goods in the national economy in a specific period ((Douglas, 1997). This means that each unit of the local currency will only be able to buy fewer goods as well as services due to a rise in price levels.
Real increases in prices
Inflation generally leads to real increases in prices. These are independent of market rigidities or economic climate swings. This results from exchange rate volatility which occurs in every sector of the national economy.
Relationship between inflation and interest rates
Generally, there exists an inverse relationship between inflation and interest rates. Inflation in the national economy lowers interest rates (Douglas, 1997). Thus, high levels of inflation equal low interests rates. People tend to borrow less when there is more money in the economy since the cost of goods and services increases to meet the existing demand. However, when there is less money in the economy, people will be encouraged to borrow more, and this in turn increases the interest rates.
Effects of inflation on prices
Inflation generally leads to a rise in price levels. This implies that the local currency loses its value as each unit buys reduced services and lower quantity goods. This causes an increase in prices of goods and services in an economy, as well as, interest rates charged by financial institutions. Increased interest rates ultimately cause reduced price ratios for any equity investment. According to Blatt (2004), inflation may bring about the imposition of price level controls to manage the low purchasing power which is a consequence of increased demand.
Effects of Inflation on exports
Inflation undermines the balance of payment as a result of the local currency devaluation (Lovasy, 1992). It increases nominal interest rates as well as financial risks on the part of exporters. The rise of inflation rates of an economy leads to a fall in the country’s global share of exports. It makes the goods produced in the country to be relatively expensive. This could lower exports as demand for such goods abroad decrease, thus, leading to a fall in net exports of a country. On the other hand, inflation leads to a weaker currency which in turn encourages more exports as it lowers the floating exchange rate as well as a specific currency’s relative purchasing power. This benefits the country’s exporters. In times of inflation, the weaker currency creates an opportunity to make more profit by exporting.
Effects of inflation imports
Inflation in a country could encourage more imports as goods produced in other countries to become relatively cheap. This in turn causes an increase in import penetration in the domestic market (Lovasy, 1992). However, this makes the imports more costly as the exchange rate between the local currency and other international currencies falls. This again puts increasing pressure on inflation. On the other hand, inflation could compromise the quality of goods being imported as lower quality goods are brought into the country cushion it against inflation.
Effects of inflation on employment
When a country’s share of exports falls and the import penetration increases, it means that the country’s production is negatively affected. Eventually, this automatically leads to a drop in the rate of economic growth as well as employment level. This implies that inflation increases the level of unemployment.
Effects of inflation on GDP
Inflation normally causes higher nominal interest rates, which usually brings about a deflationary effect on GDP. During the times when a country is experiencing inflation, the cost of producing some goods becomes high. This could lower the country’s GDP.
Effects of inflation on currency
Inflation could lead to increased importation. When this happens, the exchange rate for the local currency depreciates. This occurs because the country’s domestic firms supply more of the local currency to buy imports (Mills, 1996). This increase in the supply of the local currency causes depreciation in its value. The local currency, therefore, becomes weaker against other international currencies.
Effect of inflation cash flow
Inflation causes discounting of cash flow as the value of money is adjusted to reflect the increase in value when invested (Mills, 1996). It generally lowers the value of money such that the value of the same amount of money at the present is higher than that of the same amount in the future.
Inflation generally leads to an increase in the prices of services as well as goods. This normally lowers demands for the same and in turn, creates an imbalance in supply and demand and devaluation of the local currency. Currency devaluation destabilizes the economy and the economic growth of a country.
Blatt, D. (2004). Understanding inflation: So, what’s to worry about anyway? Futurecast, 6 (2).
Douglas, J. (1997). Short term interest rates as predictors of inflation: A comment. American Economic Review, pp. 476-77.
Lovasy, G. (1992). Inflation and exports in primary producing countries. International Monetary Fund, 9 (1).
Mills, G. (1996). The impact of inflation on capital budgeting and working capital. Journal of Financial and Strategic Decisions, 9 (1).