Why should we be concerned with the problem of inflation? The answer lies in two facts:
I. Left to itself, inflation would move from its initial beneficiary stage to that of a harmful one. For this reason, it is necessary to prevent inflation from gaining strength,
II. A stronger inflation is more difficult to control than a mild one. And there is no way to control a hyperinflation.
The beneficial effects of inflation are limited to only its initial phase when the price rise is sufficiently mild. During that period, there is a favorable impact upon both output and employment. The increase in prices and distributive inequalities are more than counterbalanced by gains in output and employment.
However, once inflationary process gathers some strength, its ill effects come to dominate the scene. These have been discussed above and would be only briefly enumerated here.
1. Right from the beginning, inflation adds to inequalities of income and wealth. However, in its last phase, it is not longer able to do so because money ceases to bean acceptable store of value. It is a generally agreed statement that inequalities reduce aggregate social welfare and should be avoided provided, in the process, production activity does not suffer.
2. Every economy needs a continuous addition to its productive capacity for which it should encourage capital formation. In a money economy, capital formation takes place when a part of money income is saved and transferred to the investors who, in turn, use it for investment and capital formation. However, inflation, by its very nature, discourages saving activity. It makes consumption more attractive than saving.
The adverse impact on saving and capital formation is more serious for-an underdeveloped country because it needs a higher rate of capital accumulation.
3. Inflation leads to a shift in the asset preference of wealth holders. Their preference for tangible assets may be counterbalanced, in the initial phases of inflation, by an increase in interest rate. However, in later stages of inflation, even an upward movement in interest rate fails to neutralize the shift in asset preference.
4. Inflation leads to balance of payments problems. When domestic prices rise faster than prices in foreign countries, exports tend to lag behind imports. The, rate of exchange also tends to depreciate both on account of falling purchasing power of currency within the country and adverse balance of payments. In some cases, there may also be an outflow of capital. A developed country may be able to handle the problem of adverse balance of payments through structural adjustment, but a developing country is not able to do so easily because they suffer from large institutional and other rigidities.
5. Inflation distorts the financial system of the country. In its initial stages, the system is able to withstand its adverse effect because the financial institutions by their very nature tend to ignore the purchasing power of money and operate with reference to interest rates and maturity of financial instruments. However, when inflation gathers strength, the financial system cannot withstand it and collapses.
6. Once inflation crosses its earlier phases, strain on the financial system, speculation, expectations of further price rise and similar other forces lead to an increase in unemployment and a fall in output. Eventually, in the final phase of inflation, the output and employment levels fall to abysmally low levels.
7. First Inflation is a hidden tax as it leads to fall in purchasing power of money. It happens particularly when authorities resort to deficit spending when their tax receipts lag behind and their expenditure does not decrease. The taxpayers therefore lose on account of reduced purchasing power of their money incomes. In other words, the authorities are able to collect resources from the taxpayers without specifically levying additional taxes on them. Secondly, when prices rise, the fixed income earners find that the purchasing power of their money incomes is falling while the real income of the profit earners is increasing. When inflation becomes still stronger, the holders of financial wealth also lose. This way, inflation is a hidden tax by entrepreneurs on consumers and on recipients of contractual incomes.