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.
Inflation in New Zealand at a faster rate relative to our trading partners can harm exporters and benefit importers. New Zealand firms exporting their products overseas will find it more difficult to sell their products because they are less competitive price wise. Local producers may find it difficult to complete in domestic markets because of relatively cheaper foreign imports. Declining exports and increasing imports can lead to deterioration in the balance of payments. High inflation in New Zealand may see nations trading elsewhere while a lack of business confidence because of the perceived higher risks may see firms investing elsewhere. This high inflation will slow growth and employment through the dampening effects on investment and declining exports.
The effects of inflation - Understanding Economic Issues by Dan Rennie was used as my guide - this material is original.