Page 107 - DECO502_INDIAN_ECONOMIC_POLICY_ENGLISH

Unit 9: Inflation: Nature and Extent

Borrowers and lenders : In general, borrowers gain and lenders lose during the period of Notes
inflation. For example, suppose a person borrows ` 5 million at 12 percent simple rate of interest
for a period of five years to buy a house. Suppose also that escalation in property prices is such
that property prices double every 5 years. After 5 years, the borrower would pay a total sum of
` 8 million whereas the price of house rises to ` 10 million. The borrower gains by ` 2 million.
The lender loses by the same amount in the sense that had he bought the house himself, his
asset value would have risen to ` 10 million.
The government : The government is a net gainer during the period of inflation. In order to
analyze the government’s gain from inflation, let us consider the government as a taxing and
spending unit and as a net borrower. As regards the effects of inflation on tax revenue, inflation
increases revenue yields from both, the direct and indirect taxes. Consider first the direct taxes,
viz., personal and corporate income taxes.
Inflation increases tax yields from personal income tax in at least three ways. One, inflation
redistributes income generally in favour of higher income groups. This kind of income transfers
enlarge the tax base for the personal income tax. As a result, the yield from the personal income
tax increases. Two, inflation increases the nominal income at the rate of inflation, real income
remaining the same. As a consequence, an income which was non-taxable prior to inflation
becomes taxable after inflation. This also enhances the tax base and, therefore, the tax revenue.
Third, with the increase in the nominal income due to inflation, incomes taxable at lower rates
becomes taxable at a higher rates. This increases the yields from personal income tax.
4. Effect of Inflation on Economic Growth
The effect of inflation on economic growth can be examined at both theoretical and empirical
levels. Let us first examine the issue of inflation and economic growth at theoretical level.
Theoretically, the rate of economic growth depends primarily on the rate of capital formation
which depends on the rate of saving and investment. Therefore, whether inflation affects
economic growth positively or negatively depends on whether it affects savings and investment
positively or negatively. Most economists hold the view that there is a positive relationship
between inflation and saving and investment and, therefore, inflation is conducive to economic
growth. Two arguments are put forward in favour of this proposition.
First, during the period of inflation, there is a time-lag between the rise in output prices and rise
in input prices, particularly the wage rate. This time-lag between the rise in output prices and
the wage rate is called wage-lag. When the wage-lag persists over a long period of time, it
enhances the profit margin. The enhanced profits provide both incentive for a larger investment
and also the investible funds to the firms. Firms plaugh back their profits for higher profits.
This results in an increase in investment, production capacity and a higher level of output.
Second, inflation tends to redistribute incomes in favour of higher income-groups whose incomes
consist mostly of profits and non-wage incomes. This kind of inflation-induced redistribution
of incomes increases total savings because upper-income groups have a higher propensity to save.
The increase in savings increases the supply of investible funds and lowers the rate of interest.
Since investment is the function of interest rate, other factor given, a lower rate of interest
increases investment. With increase in investment, production capacity of the economy increases.
This causes an increase in the total output, which means economic growth.
5. Effect of Inflation on Employment
Economic growth and employment go hand in hand. It may thus be construed that inflation
has promotional effect on employment. It is a widely accepted view that a moderate rate of
inflation helps economic growth which creates additional employment opportunities. Since
inflation affects growth variables—savings, investment and profits—favourably, it affects
employment favourably too. The economists have found that the greater the rate of investment,
the greater the rate of employment till the economy reaches the full employment level.
However, a very strong conflict arises between growth and employment at a high rate of inflation.
While a high rate of inflation increases employment, it affects growth adversely. Besides, inflation
as a means to growth and employment involves severe economic and social costs in terms of

LOVELY PROFESSIONAL UNIVERSITY 101