Wednesday, December 31, 2008

Impact of Hyperinflation

We are used to having low inflation. In living memory we have had rates of 10% and upto 28% in the 1970s. But, generally, we are used to relatively low inflation rates. Prices do rise, but, the rate is manageable. The whole economy is geared upto dealing with low inflation. What would be effect on the the economy if we ever had an inflation rate of over 100% or even 2000% ?

Contracts. Suppose you are a firm and assuming constant inflation you make a deal to deliver rental DVD's at £20 a month for the next 12 months. Such contracts are very common - some may even last for longer. If inflation stays at 2% everything is fine. However, if inflation jumped 100%, then by the end of the year a firm would find its costs would have increased 100% (e.g. postage rates can easily be changed by Royal Mail) but revenue stays the same. Therefore, by the end of the year you are making a loss and could be forced out of business. The firm could try breaking its contract and change prices, but, if you break a legal contract you could be sued. Thus hyperinflation can make contracts worthless.

Debts. Suppose you buy a Plasma TV for £400 on a 3 year interest free credit deals. This means a fixed monthly plan is set up for the next 3 years. The firm is assuming inflation stays low, but, if inflation rose to 100%, the monthly payments would fall in real value. (your wage will increase but debt payments won't) By the end of the 3 year deal, the firm would have lost out quite considerably. The person who bought on credit will find it much easier to pay the loan back. His wage will rise with inflation so the fixed monthly payments will be easier to pay back.

If you have a fixed repayment plan for a mortgage you will benefit as well.

Savings If inflation increased to 10%, Central banks may increase interest rates to 12% therefore savers will not see a reduction in the real value of their money. But, if inflation goes upto 100%, interest rates will probably not keep up. Therefore, savers will see the value of money declines. Their savings could be wiped out. This also causes financial panic - what is the point of keeping money in a bank if it is going to become worthless. This can create a dash for assets. People will try to convert any money into gold, furniture, antiques, foreign currency - anything to protect the value of savings. This can cause an outflow of money from the country an an outflow from banks leading to a fall in normal business practices.

Menu Costs. Inflation of 2%, means you can change prices once a year. Inflation of 500% means you probably have to update them every day. Time and resources are thus wasted.

Practical costs. High inflation means people will want to spend as soon as they get paid. During hyperinflation, people may seek to get paid twice a day and then spend it as soon as possible.

Lower Investment. With such disruption, firms will not want to invest.

The more you look around the economy, the more you realise how we take low inflation for granted and how much disruption would be caused by even a medium level of inflation.Hyperinflation may make interesting pictures - but, it's no joke for those caught up in the crisis.

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