How Inflation Hurts

Inflation on Friday crossed its own 13-year high at 11.42 per cent and experts believe it will continue to rise in the coming weeks. Markets plunged due to negative global cues and high domestic inflation. But why are the markets so much worried about high inflation. What are the repressions that the country and the different economic agents in the economy can face due to high inflation? We take you through some of the areas where high inflation can do some severe damage and this is why markets are so worried about inflation.

How it hurts different economic agents in the economy?
Individuals (consumer/investor): 10 per cent inflation for a consumer means that he pays Rs 110 for the same quantity of goods for which he paid Rs 100 last year. This means a direct cut in savings. Inflation also eats into returns from fixed investments. For example, if you are invested in an instrument where the yield is 8.5 per cent, at 11.4 per cent inflation the actual return is (-) 2.92 per cent. High inflation also results in high interest rates, which increases the interest payments on loans. As a result individuals are not able to save at earlier levels.

The producer
Higher inflation leads to lower demand for goods and services as the purchasing power of consumers go down. It also adds to the cost of production as input cost go up. Producers, at times, due to higher competition are not able increase prices, which lead to lower profits and lower return on investments. Higher interest cost also affects producers as their cost of borrowing goes up resulting in higher interest payments, which leads to higher production cost and lower profits.

The state
The government is also affected by higher inflation, which eventually affects producers and consumers. Lower consumption results in lower demand and lower sales, which reduces profits for producers. Lower profitability results in lower tax collection for the government. Low tax collection leads to higher deficit. Higher deficits means either more borrowing from the markets or printing currency. Printing currency will add to the inflation, as there will be more money in the hands of consumers with the same availability of goods. Higher borrowing will increase the interest burden on the exchequer and will also suck money from the system, which otherwise would have been used by private sector for investment purposes. Higher level of borrowing also results in higher interest rates as the amount for lending purposes get reduced by government borrowing
Higher inflation is a total loss-loss situation for the economy.

Is there any other implication?
Implications of high inflation are much deeper than what it appears.
Inflation means lower consumption demand. Inflation and interest rates go together which means lower investment demand. A low investment result is lower level of employment and low growth (GDP). Lower employment means low-income, low income will lead to low consumption, and lower consumption means low production. This cycle will keep on repeating it self and every time the growth will decelerate which will negatively affect employment and income and the economy will settle for lower growth every time.

Inflation also has effects on external economy and exchange rates.
Exports suffer because of high inflation. First due to state intervention as governments do not allow goods to flow out when there is high demand and prices are rising in domestic economy. Secondly, due to high inflation, the cost of production goes up which makes goods uncompetitive in the world markets. On the other hand the imports goes up in order to check domestic prices leading to greater trade deficit, which results in deprecation of currency.
Deprecation of currency is favorable for exports but state controls and high inflation at times do not allow countries to takes advantage of weak currency. Further deprecation of currency hurts FII investments as the currency risk eats into the returns. Higher fiscal and trade deficit also discourages direct investments as higher deficits leads to greater financial instability.