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FINANCIAL CHRONICLE™ » CORPORATE CHRONICLE™ » Inflation is better for the economy of Sri Lanka?

Inflation is better for the economy of Sri Lanka?

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Sstar

Sstar
Vice President - Equity Analytics
Vice President - Equity Analytics

What are the positive and negative effects of inflation?

Inflation is defined as a persistent increase in the general price level. It can take the form of creeping inflation of several percent per year. This is viewed as healthy for the economy because it means that some level of economic growth is occurring in the economy. On the other hand, hyperinflation can take place in an economy. There is no figure at which inflation can be deemed hyperinflation but a figure of annual inflation as high as 100% could be regarded as such. The economic effects of each of these are different so it will be important to note that I will be looking at creeping inflation. Inflation affects a large number of economic factors within the economy such as unemployment, growth, the balance of payments, distribution of wealth and taxation revenues.

Inflation is viewed as being undesirable because of some serious economic and social effects. Inflation impacts on income distribution making an random redistribution of real income. Those receiving fixed money incomes (e.g., pensioners, beneficiaries etc.) are usually disadvantaged because often their incomes are not adjusted upwards fast enough to compensate for the effects of continually rising prices. Their real incomes (i.e., the goods and services their incomes will buy) will fall. Individuals whose incomes rise more rapidly than the inflation rate will experience increasing real incomes. Generally, the pattern of income distribution tends to become more unequal than it was before inflation. If the rate of inflation is high, individuals with money tend to buy real assets such as property, gold and antiques, which often increase in value faster than the rate of inflation. This group will gain by increasing the size of their share of the nation's wealth.

Inflation tends to increase spending and encourage borrowing at the expense of savings. If prices are rising quicker than incomes, individuals will tend to buy at current prices before goods and services become more expensive and less affordable. Some consumers may buy using higher levels of debt (i.e., borrowing) than otherwise might the case. Savings may be discouraged because with high inflation when the money saved is repaid, it can be worth much less than when it was lent and the real rate of interest may be low. The real rate of interest rates fail to keep pace with inflation the saver loses purchasing power, i.e., their ability to buy things falls. Rising prices are a boon to borrowers because the repayment of interest and the sum borrowed (i.e., the principal) is with lower valued money. Inflation reduces the real value of the amount they owe, as the sum repaid has less purchasing power. Of course, any gain by borrowers must be weighed against the interest they must pay.

Investment, in economics, means the creation of new capital goods. Investment can only take place if there is saving. Inflation encourages spending and discourages saving, so funds that might otherwise have been available for investment tend to dry up. With lower levels of investment there is likely to be a slowing of the rate of growth of national output (GDP). This in turn leads to a reduction in new jobs and so can increase the level of unemployment. Inflation can distort market price signals and the market may fail to allocate resources efficiently. Planning and investment decisions become more difficult to predict as firms are unsure what will happen to prices and costs during times of inflation. If firms are unable to pass on the increase in costs to consumers this will impact on profits possibly causing some firms to close or cut back production and subsequent employment.



Last edited by Sstar on Tue Jul 22, 2014 9:28 am; edited 4 times in total

Sstar

Sstar
Vice President - Equity Analytics
Vice President - Equity Analytics

IMF's Lagarde sees risk of long-term low inflation in euro zone

(Reuters) - The euro zone risks an extended period of low inflation, IMF chief Christine Lagarde said on Monday, urging central bankers to be ready to act to protect an incipient economic recovery.

Speaking at an economic forum in the northern Spanish city of Bilbao, Lagarde said the International Monetary Fund saw low inflation in the economic bloc which could affect consumer spending, key to pulling the euro zone out of prolonged economic weakness.

"We're saying that the potential risk is out there. We range that risk at 15-20 percent, which is why we recommend that central bankers guard against it and have available the tools that could respond to that in terms of monetary policy," IMF Director Lagarde said.

Euro zone inflation is running at 0.8 percent, far below the European Central Bank's target of just under 2 percent, adding to pressure on the central bank to ease its monetary policy at its monthly meeting on Thursday.

Deflation, an extended period of falling prices, can undermine an economy as families and businesses delay spending on the chance of potential future bargains, creating a loop of low consumption and ever lower prices.

Lagarde's concern was echoed by others at the day-long event.

"There is certainly a risk (of deflation in the euro zone), but I am not worried. It comes from two factors in Europe, including the low cost of energy, food and other commodities, and the second is from the (fiscal and economic) reforms, certainly in the south of Europe, which have brought down the cost of production leading to low inflation," Jeroen Dijsselbloem, head of the Eurogroup of wuro finance ministers, told journalists.

Head of the Organisation for Economic Co-operation and Development Angel Gurria also said that, while he didn't believe there was imminent danger of euro zone deflation, there was a possibility of low price rises.

"There isn't enough economic strength and that's where there must be work," Gurria said

(Reporting by Paul Day, Writing by Fiona Ortiz; Editing by Julien Toyer/Ruth Pitchford)

Sstar

Sstar
Vice President - Equity Analytics
Vice President - Equity Analytics

Economists generally agree that a touch of inflation can have a positive effect. They point out that inflation can erode the cost of debt over time. More importantly, perhaps, it can boost wages and growth. Here's an example from my book of how this can work.

Imagine a man with 10 children. He moves to a small town in the country that has just one store, which sells stuff that people in the country need, like hammers and tarps and animal feed. The McGivens store has some candy, but not much, because there aren't that many kids in the town.

The newcomers kids love candy, however, and the first thing they do when they arrive is go exploring the town, to see what they can buy with their pocket money. Rose, the eldest, leads the procession, and it doesn't take them long to find the McGivens store.

Children (in unison): Hello Mister!

Mr. McGivens: Good heavens! Where did you lot spring from?

Rose: We've come from Chicago.

Mr. McGivens: Well, that's a long way away.

Rose: Yes it is, and we're hungry.

Children: We want candy!

Mr. McGivens: Well, I don't have much in the way of candy here. I have some Red Strings and some lemon chews, and a big jar of hard candies. What would you like?

Rose: We've each got two dollars in pocket money, so that's $20 altogether. How much are the hard candies?

Mr McGivens thinks for a moment. Usually he charges five cents a candy, because so few people want to buy them. But today the situation has changed. Now there is suddenly a lot more candy money in the town, and only one place to spend it: his shop. An opportunity has presented itself.

Mr. McGivens: The hard candies are eight cents each. The lemon chews are ten cents.

Rose: Okay. We'll take a hundred lemon drops and … 125 hard candies, please. Here's $20.

Mr. McGivens: Here's your candy

Children (in unison): Thank you!

They march out of the ship, just as Henry Tomkins enters.

Henry Tomkins: Afternoon, John.

Mr. McGivens: Afternoon, Henry.

Henry Tomkins: I need a new shovel and a bag of fertilizer, please. And I'll take a dozen of those lemon drops.

Mr. McGivens: That's $30 for the shovel, $25 for the fertilizer, and a dollar twenty for the candy.

Henry Tomkins: A dollar twenty? They were sixty cents yesterday!

Mr. McGivens: Sorry Henry. Inflation.

The problem with inflation is that it makes your money worth less. Mr. McGivens store is a micro economy that has been flooded by the children’s candy money. The introduction of their $20 has doubled the price of the candy that Henry Tomkins likes to buy, or in other words his dollar can only buy half the candy it was able to buy the previous day. His dollar, then, has been devalued by 50 percent.

But inflation isn't all bad. In fact, governments quite like inflation – in moderation. Inflation may devalue existing currencies a little bit, but that can be offset by the fact that there’s a lot more money coming into the system: money to spend, or invest, or build, or even hire more staff. So, in moderation, inflation can help keep people employed.

Take Mr. McGivens. Now that’s he’s making a bit more money from his candy, he has to think about how to use those profits. He could spend the money. Or he could plow it back into his business. Either way, that keeps the money in the system. Say he spends the money on a new tie for himself. That helps the retailer who sells him the tie, plus the tie-makers, and the silk growers: there's a whole chain reaction through the tie business that can help keep people employed. In plowing the money back into his business, Mr. McGivens could refurbish his store, which would help local lumber suppliers and building workers. Or he could hire someone one day a week, to help him with a stock count. That would give that employee an income, some of which she would likely spend, again sending positive, job-sustaining ripples through Mr. McGivens’ hometown.

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