Price Level and Inflation: Saving and Investment Distortions

Inflationary Distortions in Saving and Investment Erratic inflation is particularly troublesome for long-term contracts. It increases the risk involved in estimating the returns on investment projects by making it difficult to anticipate future input and output prices. This might lead to distortions in decisions to save and invest and cause investment to be reduced below the efficient level. Let's first look at how inflation can reduce investment by increasing the cost of acquiring new plants and equipment. Capital consumption allowances (depreciation) represent a cost of production that can be deducted from business income before computing taxes. The sum of capital consumption allowances deducted over the life of an asset equals its purchase price. The real value of capital consumption allowances falls as a result of inflation. This means the tax deduction that business firms get for purchasing capital is worth less and businesses will pay more in taxes. The higher the rate of inflation, the less will be the gain in after-tax profits for business from purchasing investment goods. Inflation, therefore, reduces the incentives of businesses to make investments and could adversely affect the rate of economic growth for the economy. Now let's look at how inflation can reduce the supply of saving to fund investment. Remember that inflation erodes the value of bank deposits and other assets such as bonds that are fixed in monetary value. If inflation soars, savers might seek to liquidate their financial assets and purchase land or items like antiques and other collectibles because during periods of inflation the prices of land and antiques are likely to soar. Unfortunately, this makes less funds available for productive investments like new factories that ensure future increases in labor productivity and increased future employment opportunities for workers. This puts further upward pressure on interest rates. Inflation not only distorts current choices but also can decrease confidence in the nation's financial markets, thereby adversely affecting future opportunities as the amount of saving channeled into productive investment is reduced. A nation's real GNP growth rate can be adversely affected if inflation reduces business investment. When inflation reaches excessive levels, the central banking authorities of a nation, such as the Board of Governors of the Federal Reserve System in the United States, usually are obliged to take action to raise interest rates and reduce the supply of credit. If monetary authorities must tighten credit severely to achieve their objective of reducing the rate of inflation, the result could be a recession. This has happened in the past. For example, the recession of 1982 in the United States was a direct result of economic policies designed to reduce the rate of inflation. The Disastrous Effects of Hyperinflation Extraordinarily high rates of inflation are likely to be more costly than modest inflation. If people expect very high inflation, they'll try to spend their earnings as quickly as possible and avoid holding money that will quickly have its purchasing power eroded. For example, if you anticipate that prices will rise 10 percent per week, you'll be eager to be paid once or twice a day so you can spend your earnings before the purchasing power of the dollar deteriorates! During the 1920s, inflation in the German Weimar Republic reached such astronomical rates that it was dubbed hyperinflation, defined by the International Monetary Fund as inflation at an annual rate of 200 percent or more prevailing in a nation for at least one year. In 1922 the annual inflation rate in Germany exceeded 5,000 percent, because the Weimar government sought to pay its bills by printing money. In 1922 the money stock in Germany grew by about 30 percent per month. Prices rose almost hourly! German currency became worthless and was used as kindling for stoves. Once people began to anticipate the inflation they tried to unload cash balances, which caused further inflationary pressures by increasing the demand for goods and services. The cost to Germany was tremendous. Credit markets virtually collapsed, as no one was willing to take the risk of lending money. There was a massive redistribution of income that literally wiped out the savings of millions and benefited those who were heavily in debt. People demanded to be paid at least once a day and spent an inordinate amount of time each day trying to unload their earnings before the price level rose again! The ultimate solution for Germany was a monetary reform in 1923 that changed the currency and promised to limit printing of the new currency. Hyperinflation is not a historical relic. In 1985 the rate of inflation in Bolivia was 11,749 percent! An item that sold for the equivalent of 50 cents at the beginning of 1985 cost more than $5,000 at the end of the year! Bolivia managed to get its inflation under control by 1990. However, another South American nation, Argentina, was still struggling with the horrors of hyperinflation in 1990. Prices in Argentina increased by over 5,000 percent in 1989, and in some months of that year the annual rate of inflation was over 12,000 percent. The result was social chaos and a collapse of monetary and financial markets. As of 1990, many prices in Argentina were quoted in U.S. dollars, and Argentines who wished to pay in their own national currency had to pay at the current rate of exchange for dollars that fluctuated hourly! According to the International Monetary Fund's definition, in addition to Argentina, the nations of Peru, Brazil, Nicaragua, Poland, and Yugoslavia were also suffering from hyperinflation in 1989.