Effects of Inflation in the Economy | Effects on Production | Effects on Consumption | Effects on Distribution

• Inflation has serious social and economic effects. Some economists have named it legal dacoits. It invisibly imbalance economic factors and delay the speed of economic growth. The following are the main effects of inflation.

Effects on Production

1. Decrease in the quality of goods: The demand for goods increase due to inflation. So, any type of goods can be sold. As a result, the profit seekers lessen the quality of goods to increase the profit.
2. Reduces saving: Due to inflation, most of the income is spent on consumption. So the saving reduces. As a result, there is less capital investment.
3. Encourages holding and speculation: The producers start to store the necessary goods. Due to this, the goods become even scarce; the businessmen hide the goods and create artificial scarcity, for black marketing.
4. Reduction in productivity: In the time of inflation, there is less capital formation. As a result, it is difficult to make available factors of production. It brings uncertainties in the economy, and entrepreneurs become discouraged in the production.
5. Devaluation of money and loss in faith: People have less trust of money due to the devaluation of money and its decreasing purchasing power. Foreign investors also can return their investment due to the loss of faith.

Effects on Consumption

1. Change in consumption pattern: In the time of inflation, the demand for quantity decrease as the price of the quantity increases. Those who have various sources of income buy luxury goods, foreign goods and goods of comfort but those who have limited source of income start to buy only essential goods. Most of the consumers start to consume artificial goods than natural ones.
2. Debt instead of saving: In the time of inflation, the consumer surplus slowly decreases because he has to pay more than he wants to pay. If there is high inflation, he will get loan.
3. Unequal consumption and lifestyle: In the time of inflation, the lifestyles of rich and poor will become more polarized. Those who have only limited income, is compelled to buy only the essential goods. Due to this, life becomes more difficult. But those, who have various sources of income feel opposite of that.

Effects on Distribution

1. Fixed income groups: Government officials, pensioners and those depend on post savings are the fixed income group. In the time of inflation, general price increases, so the expenditure on living increases and the life becomes harder.
2. Creditors and debtors: In the time of inflation, creditors are in loss and debtors are in profit because of the decrements in the purchasing power of money. As the creditor give the money having more purchasing power and get it back when it has less purchasing power. Therefore, they get in loss.
3. Salary and wage earners’ group: This group will be in hard time as the expenditure of living increases where as wage and salary do not increase.
4. Merchants and industrialists benefited: In the time of inflation, merchants and industrialists get sudden profit. The price of assets (stock) increase but the cost of current capital does not increase so much, so merchants and industrialists get extra profit.
5. Effect on Balance of Payment: Inflation has negative effect on balance of payment. Indigenous goods happen to be more expensive than foreign goods. So the farmer cannot compete with foreign goods. As a result, import increase and export decrease. Thus, balance of payment becomes negative. In the long run, it creates scarcity in the foreign exchange.

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• Goal / Role of monetary policy in an underdeveloped economy

• Incomes Policy, Need and Working of Incomes Policy

• Meaning of Marketing Environment and Scope of Marketing Environment | Micro and Macro Environmental Forces

The Theory / Principle of Acceleration | Limitations and Assumptions of Acceleration Theory

The multiplier and accelerator are not rivals but parallel concepts. While the multiplier shows the effect of investment on consumption (and employment), the accelerator shows the effect of a change in consumption on investment.

According to Hayek, “Since the production of any given amount of final output usually requires an amount of capital several times larger than the output produced with it during any short period (say a year) any increase to final demand will give rise to an additional demand for capital goods several times larger than the new final demand.”

 

The principle of acceleration states that if demand for consumption goods rises, there will be an increase in the demand for the product. The accelerator therefore makes the level of investment a function of the rate of change in consumption. In other words, the accelerator measures the changes in investment goods industries as a result of changes in consumption goods industries.

The idea underlying the accelerator is not so much one or ever-rising demand as of a functional relationship between the demand for consumption goods and the demand for the machines, which make them. The acceleration coefficient is the ratio between the induced investments to a net change in consumption expenditure.

Symbolically, 

α = ∆I / ∆C 

where, α stands for acceleration coefficient;

           ∆I denotes the net changes in investment outlays and 

           ∆C denotes the net change in consumption outlays.

Suppose an expenditure of 10$ billion on consumption goods leads to an investment of 20$ billion in investment industries, and then the accelerator is 2. It could be one or even less than that. In actual practice, however, increased expenditures on consumption goods always lead in increased expenditures on capital goods. Hence accelerator is usually more than zero. Where a good deal of capital equipment is needed per unit of output, acceleration coefficient is positive and more than unity.

Sometimes, the production of increased consumer goods does not lead to an increase in the capital equipment producing these goods. The existing machinery also wears out on account of the constant use, with the result than the increased demand for consumer goods cannot be met. In the absence of induced investment and the acceleration effects, the increase demand of consumption goods leveled off and the accelerator, which measures the effects of induced investment as a result of changes in consumption, did not seem to work during these years.

The actual basis of the acceleration principle is the knowledge that the fluctuations in output and employment in investment goods industries are greater than in consumption goods industries. Acceleration has greater applicability to the industrial sector of the economy and as such it seeks to analyze the problem as to why fluctuations in employment in the capital goods industries are more violent than those in the consumption goods industries. There would be no acceleration effects in an economy that used no capital goods. Hence, acceleration principle has been widely used to explain fluctuations in economic activity, especially in the investment goods industries.

Thus, the acceleration principles hold that investment demand is dependent on increases in output, because such increases put pressures on firms to expand their stocks of capital goods. In this theory, investment occurs to enlarge the stock of capital because more capital is needed to produce more output. Firms may be able to produce more output with existing capital through more intensive use, but there is, at any time, a particular ratio of capital to output that firms consider optimum. At any time, there is a particular ratio that is the desired ratio for the economy as a whole over time, this ratio will changes as the mix or output changes. In order to reduce the complication, it is assumed that this ratio remains unchanged or constant over time. With K representing the capital stock, Y the level of output and W the capital output ratio, we have 

K = W Y

K (the desired stock of capital) will change over successive time periods only with changes in output (Y). Denoting a particular time period by t, preceding time periods are t – 1 and t – 2 and future of subsequent time periods are t + 1 and t + 2. Assume that in the preceding period (t – 1) the desired capital stock was enough to produce the level of output of the period t – 1. That is

Kt-1 = W Yt-1

Its output rises from Yt-1 to Yt, the desired capital stock would also rise from Kt-1 to Kt that is:

Kt = WYt

This increase in the desired stock of capital is Kt – Kt-1

To get this increase in capital stock, additional net investment is needed – this net increase in net investment expenditure is equal to the change in capital stock, that is,

It = Kt – kt-1 ………………………. (i) 

Where, it is not investment in period t. By substituting WYt for Kt and WYt-1 for Kt-1, we get

It = WYt – WYt-1 = W(Yt – Yt-1) …………………………….. (ii)

This equation simply means that investment during a particular time period (t) depends on the changes in output from ‘t-1’ to t multiplied by capital output ratio (W). If Yt > Yt-1, the equation shows that there is positive and investment during the period ‘t’. If, however, we want to show gross rather than net investment, all that it needed is to add replacement investment to both sides of the equation. This replacement investment is taken to be equal to depreciation and in shown by Dt, we have thus;

It + Dt = W (Yt – Yt-1) + Dt

The sum of It and Dt cannot be less than zero. If Ig represents gross investment in period t. We have, 

Igt = W (Yt – Yt-1) + Dt …………………………. (iii)

Investment will respond to changes in the level of output shown by the equation only if certain assumption are satisfied, the most important being the absence of excess capacity, if Xt shows the excess capacity at the beginning of the period t, we may rewrite equation (iii) as;

Igt = W (Yt – Yt-1) + Dt – Xt

Whatever the level of gross investment might otherwise be in t, it will be reduced by the amount of Xt. It’s the value of W(Yt – Yt-1) + Dt happened to be equal to an less than Xt then Igt would be zero, the minimum possible for gross investment in plant equipment.

Limitations and Assumptions of Acceleration Theory

The acceleration value may be considerably reduced as account of some practical limitations and assumptions:

1. No excess capacity: If there is already excess capacity in the consumer goods sector, a rise in demand for consumer goods will not lead to any induced investment or acceleration effects, because the increased demand may be met from the existing capital and machinery without producing additional capital goods. This will be a case of zero gross investment and is the typical case during the initial period of recovery phase of the trade cycle.
2. Surplus capacity: The operation of the principle depends upon the presumption that there is surplus capacity in the investment goods industries. If it were not so and no excess capacity existed in machine making industries, an increase in the derived demand for machines could not result in an increased supply of machines. Hence, the principle of acceleration depends upon very tough conditions that there shall be excess capacity in one industry (investment industry) but no excess capacity in other (consumer goods industries).
3. Capital output ratio: It is based on the assumption that there is a constant ratio of the output of consumer goods and capital equipment needed for their production. In reality thus ratio is not constant. Apart from the inventions and improvements in the technique of production, existing capital equipment may be worked more intensively. The capital output ratio also varies in different phases of the business cycle and does not remain constant.
4. Nature of demand: An increase in the demand for consumption goods must be more or less permanent in nature to have acceleration effects. A purely temporary increase in the demand for consumer goods will not lead to any addition in the capital goods. Durable capital goods are expensive and no producer will order capital goods that increases in demand in short level. This also shows that the acceleration is not based on merely technological factors but also no profit expectation.
5. Availability of resources: The working of acceleration principle is further impaired by the availability of resources and the ability of the machine making industry to produce more machines. In order that the increased demand for capital goods is followed by an increase in the production. There must be enough unemployed factors available for employment in the capital goods industries. This is possible only when there is widespread unemployment in the economy.
6. Elastic credit supply: The elastic supply of money and credit is another factor, which helps, in the smooth working of the acceleration principle. Whenever there is induced investment as a result of induced consumption, enough money and credit should be forthcoming for investment in investment goods industries. A scarcity of money and credit will raise the rate of interest and will make investment financed by borrowed funds easier. It is, therefore, essential that the rate of interest not be allowed to rise and that there is enough credit to allow for the acceleration effects to flow.

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• Calculation of National Income and Difficulties in the Calculation of National Income

• National Income: Various concepts of National Income | Gross Domestic Product (GDP), Gross National Product (GNP)

• The dispute between Monetarism and Keynesianism

Externalities in the Economy | Economic effects that occur from the production or the use of goods

Externalities are pervasive and significant phenomena in modern societies. The term externalities refer to the economic effects which occur from the production or the use of goods to other parties or economic units. It is said that public goods and externalities are not un-related. In other words, public goods and externalities are related. Externalities may affect a large number of people in a uniform manner, in which case the externality is essentially a public good (or public “bad”).

For example, education increases the skills and general welfare of the person being educated and may in addition, make the person better citizen. That is, the person’s behavior in political process may be more wise and informed, and an informed may make better political decisions. Since, such decisions affect every one, the education of each person produces an external benefit that accrues to the members of the community and the nation in which person reside.

This external benefit is a public good that is jointly produced along with the private goods (marketable skills) resulting from education.

Similarly, air pollution generated by an iron mill’s smoke and the exhaust of automobiles are public bads that are produced jointly with private goods (iron mills and private transportation). Again, the railways using a lot of coal in firing steam locomotives put the residential and other areas near the railway loco sheds to a lot of suffering on account of the smoke nuisance. These are the cost to the society but not to the individual undertaking.

In the above examples, public goods, i.e., benefits and public bads that are produced with private goods are known as externalities. These are the cost to the society but not the individual undertaking. This causes divergence between private cost (internal cost) and social marginal cost or external cost of benefit, of the goods in question. Market takes into account of internal costs and not the social marginal cost or external cost (or benefit) of the goods in question. Consumers reveal their preferences for the benefits which are wholly internalized (rival) but not for the external benefits, i.e., purification of air (non-rival). Thus, market fails to achieve efficient allocation of resources when externalities are present.

To be more clear, let the production of a commodity, say iron generates air pollution that adversely affects the welfare of the people in the surrounding community. The cost of iron, thus, have two components: (i) the cost of the labor, machines, iron ore, coal and other inputs directly required to produce the iron; and (ii) the costs borne by the members of the community in the form of air pollution damages. Market takes into account first component of the above costs but not the second. This is the cause of divergence between private cost (internal cost) and the social marginal cost (external bads). Hence, markets fail to achieve efficient allocation of resources when externalities, i.e., external costs or benefits are present.

Thus, externalities can take many forms. For example, external benefits from education: children gain from having educated parents; society benefits in so far as education reduces crime, social un-rest, unemployment and welfare costs; society benefits from an educational system that inculcates acceptable social values, improves communication and strengthen democratic institutions, on the (external bads) side are many forms of pollution and other disseminates such as congestion and noise etc.

i) Externalities in the form of external benefits

Problems of social goods-type arise not only in the budgetary context but also wherever private consumption or production activities generate external benefits. Suppose, for instance, that A derives benefits being inoculated against polio but this also benefits others, since the number of potential carriers and hence the danger of infection, is reduced. Similarly, by getting educated, A not only derives personal benefits but also makes it possible for others to enjoy association with a more educated community. Since, large number of other consumers may be affected, market does not work and a budgetary process is needed to secure preference revelation. But budgetary intervention in this case will not involve full budgetary provision rather, it will take the form of subsidy to private purchases.

ii) Externalities in the form of external costs or bads

Let us now consider a case of a commodity which generates external costs or bads. Suppose, the production of iron generates air pollution that adversely affects the welfare of the people in the surrounding community. The cost of iron, thus, has two components: (i) the cost of the labor, machines, iron ore, coal and other inputs directly required to produce the iron, and (ii) the costs borne by member of community in the form of air pollution damages. However, the second component of cost is not taken into account by the market. In fact, private activities, whether in production or consumption frequently give rise to external costs which are not accounted for by the market. Hence, public (Government) intervention is needed to get this part of the cost to be internalized.

iii) Efficiency and equity problems

In the first place, failure to account for external costs leads to an over supply of production question (i.e., here iron) and an under supply of the benefits (i.e., clean air) which are reduced by pollution. This is the efficiency problem. If the damage cost of pollution were internalized, resource use would become more efficient. The price of iron would be higher, less iron would be produced and the air quality would be improved.

Second, the existence of pollution poses distributional or equity problems. Through, the loss of environmental quality, consumers of air are forced to subsidize consumers of iron, much as they would if a tax were imposed on them (consumers of air) and transferred to the latter (i.e., consumers of iron). Moreover, the incidence of pollution damage may fall with different weight upon low income and high income families, and this affects the distribution of real income. The same goes for the cost of pollution prevention and the net gains to be derived there from.

iv) Efficient solution

It should, however, be noted that air is a public property, it is a social good. The principle of exclusion does not apply. Hence, market fail to take into account external costs or the damages caused by air pollution. The benefits of this good are shared by all those who are damaged by pollution.

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