Negative effects
High and unpredictable inflation rates are considered harmful to the economy. They add inefficiencies and instability in the market, making it difficult to make budgets and long-term plans. Inflation can act as a drag on the productivity of companies, which are forced to withdraw capital destined for the production of goods and services in order to recover the losses caused by currency inflation. Uncertainty about the future of the currency's purchasing power discourages investment and savings.
Inflation can also impose hidden tax increases: inflated incomes can mean increased income tax rates if tax brackets are not properly indexed to inflation. However, moderate inflation rates do not seem to have negative effects on economies, thus a study by Robert Barro shows that statistically, an inflation of less than 8-10% does not show a negative correlation with the country's growth rate.[17] Other empirical studies place the threshold above which inflation can be really harmful at 20 or 40%.[18][19].
The main negative effect of inflation, in a market economy, is that it destroys the price system of the economy. On the one hand, producers make their savings-investment decisions based on the information available, so in an inflationary environment they are not able to discover if a price increase is a relative effect (only to their product) or, on the contrary, it is an absolute increase (where all product prices rise). In these cases, the investor has to spend more time knowing the prices of the products and, in particular, the prices of their competition, because these become obsolete in the short term, instead of dedicating that time to their business. On the other hand, the uncertainty in prices caused by inflation also negatively affects consumers, since they must waste time researching the price of the products they consume. Therefore, this uncertainty and less information, which produces inflation, negatively affects both investors and consumers, and with this negatively affects the growth possibilities of the economy.
Firstly, the deterioration in the value of the currency is detrimental to those people who earn a fixed salary, such as workers and pensioners. This situation is called loss of purchasing power for the aforementioned social groups. Unlike others with mobile incomes, they see how their real income is reduced month by month, when comparing what they could buy with what they can buy some time later. However, it should be noted that if salaries are quickly adjusted to inflation, the loss of purchasing power of some social groups is mitigated or eliminated.
With high inflation, purchasing power is redistributed from people, businesses and institutions with nominal fixed incomes, to those with variable incomes that can keep pace with inflation. This redistribution of purchasing power also occurs among international trading partners. If fixed exchange rates exist, one economy with higher inflation than another will make the former's exports more expensive, affecting the trade balance. Negative trade effects may also arise due to instability in currency exchange prices.
Inflation is regressive") (that is, it affects sectors with fewer resources relatively more than those with greater resources) due to the Cantillon effect, which explains that newly created money is not distributed simultaneously or uniformly throughout the population but rather benefits those who print the money. uniformly throughout the population, those who first receive the money issued are least affected by the loss of value of the money.[21].
Furthermore, sectors with fewer resources use cash (or monetary balances) relatively more than sectors with more resources, and they have fewer financial instruments to hedge against inflation. On the other hand, sectors with more resources have access to more financial instruments (such as deposits that are adjusted with inflation) and with these they can better protect themselves from the loss of purchasing power that inflation produces.[22][23].
Inflation is harmful to those creditors of fixed amounts, since the real value of the currency decreases over time and their purchasing power will decrease. On the contrary, those debtors with a fixed rate will benefit, since their real liabilities will decrease.
As a consequence of the previous points, what is usually called “self-constructed inflation” arises. This phenomenon consists of transferring the increase in prices forward in time, this is because people expect inflation to continue as in previous periods. This creates an inflationary spiral, in which contracts are indexed, salaries and prices are increased due to future expectations.
Differential inflation is a situation in which two or more countries, whose economies are strongly dependent or form a special economic area, have different rates of price increases. Differential inflation, especially if it is sustained over a long period, generally causes the country with the highest inflation rates to suffer an increase in production costs and consequently a loss of competitiveness.
It is the product of the increase in the costs of an important input for the production of a good or service, for example energy, and in this way generates inflation in the rest of the economic activities.[24].
High inflation can prompt employees to demand rapid wage increases to keep up with consumer prices. In the case of collective bargaining, wage growth will be set based on inflation expectations, which will be higher when inflation is high. This can lead to a wage spiral. In a sense, inflation can generate a situation of instability that feeds on itself: inflation generates expectations of more inflation, which in turn generates greater inflation.
People tend to buy durable and non-perishable products to partly avoid the expected losses from the decline in the purchasing power of the currency.
If inflation becomes out of control (increasing), it can seriously interfere with the normal functioning of the economy, affecting its ability to produce and distribute goods, and it can also lead to the abandonment of the use of currency as a means of exchange of goods, leading to the inefficiencies of barter.
A change in the supply or demand of a good will normally modify its price, signaling to buyers and sellers how they should reallocate resources in response to new market conditions. When prices are unstable and change markedly due to inflation, price changes due to supply/demand signals are difficult to distinguish from price changes due to general inflation. The result is a loss of efficiency.
According to the Austrian theory of the economic cycle, the fractional reserve causes the decision-making of economic agents to begin to be erroneous from the moment the money supply begins to be multiplied by the existence of the fractional reserve because both depositor and borrower believe they have possession of the same capital and therefore make savings and consumption decisions that are altered with respect to the decisions they would make if the depositor were recognized as a creditor, that is, if the depositor really had his money available. This distortion in information causes inflation to arise in the different production phases and sets the economic cycle in motion. Austrian economists argue that this is the most damaging effect of inflation.
According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to highly speculative reckless lending, which increases the probability of bad investments, which in the long term turn out to be unsustainable, generating business losses, layoffs, salary reductions and consequently in consumption and as a consequence in production, with price declines staggering after the initial rise of the expansionary phase.
Positive effects
Positive effects include the ability of state central banks to adjust nominal interest rates in order to mitigate a recession and to encourage investment in non-monetary capital projects.
Keynesians believe that nominal wages are quick to rise, but slow to adjust downward. If wages are overvalued, this difference in the speed of adjustment leads to a prolonged imbalance, generating high unemployment rates. Since inflation would be less than the real wage if nominal wages were held constant, Keynesians argue that some inflation would be good for the economy as it would allow labor markets to reach equilibrium more quickly.
The main tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations, which are central bank interventions in the bond market with the aim of affecting nominal interest rates. If an economy is in a recession with low nominal interest, then the bank finds limits to reduce rates further in order to stimulate the economy (since negative nominal interest rates are impossible). This situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates remain well above zero, so that if the need arises, the bank can reduce the nominal interest rate.
The concrete experience of individual countries seems to indicate that high inflation is compatible with rapid economic growth. In the 1960s and 1970s, Brazil had an average inflation rate of 42%, but it was one of the fastest growing economies in the world, and its per capita income increased by 4.5% annually.[25] During the same period, South Korea's per capita income grew by 7% annually, despite an average rate of almost 20%.[25].
There are several explanations for this, among them is that with high inflation, the net profitability of financial investments, which is equal to nominal interest minus inflation, declines greatly and in these circumstances non-financial investment in the productive economy is more attractive. As if that were not enough, anti-inflationary policies can be harmful to the economy. Since 1996, Brazil, after suffering from hyperflation, began to control it by raising effective interest rates to 10-12% (a figure among the highest in the world), inflation fell to 7.1% but growth also suffered, which did not exceed 1.3%.[25] South Africa also had a similar experience in 1994, when it began to give absolute priority to controlling inflation and raised interest rates to Brazilian levels.