Inflation and Wealth Redistribution

We have already ascertained that inflation is a hidden tax. It is a discretionary power that governments have at their disposal to tax the people without their consent. However, that is not what makes inflation public enemy number 1 as far as economics is concerned. Not only is inflation an unjustly applied tax but when you consider whom it affects the most, the true gruesome picture begins to emerge.

Taxes are usually progressive i.e. the higher ones income, the more tax they have to pay. People on the lower end of the income are expected to contribute more. However, the nature of inflation is such that it becomes a regressive tax. Now, this is a slightly complex concept involving multiple stages. This article will make an attempt to explain how inflation causes redistribution of wealth.

Money and Resources:

To begin with, we need to have some perspective as to what money i.e. currency note really is. In simple words it is a claim on a resource. Let’s say if we somehow managed to accumulate all the money in the world that would mean that we have ownership of all the resources in the world.

Time Taken To Adjust:

Now, the key point here is that both the amount of money and the resources that are available in the world for use are not static. This means that their amounts keep changing. Let’s say because of a technological development, we can now produce 10% more with the same amount of input, the resources just went up by 10%, and however the amount of money remains unchanged.

According to the principle of the free market, sooner or later this adjustment will indeed take place and the prices will change to reflect the amount of money available in the system. However, the change is not immediate. It takes a while for the newly created money to start circulating in the system. Only once the money is circulating, do the prices start to rise.

Hence there is a time lag from the time period when money was created to the time period where prices will rise. The difference between these time periods can be called window of opportunity. If anyone gets their hands on the newly created money at this time, they would have the excess money but the prices would not have risen.

Simply put, the purchasing power would be transferred to whoever obtains the money first. As and when more transactions take place with that money, the purchasing power is constantly lost.

The First Layer:

To consider the example, let’s consider the case of the government. Now, the government is the one that is creating the money. They then use this money to pay off their debts. Till the time the government hasn’t actually paid off its debts, this money is technically not in the system at all! Hence, this money has not caused inflation till that point in time. However, once the government does make the payment, the money enters the money supply and some of the value is indeed lost. Therefore the government is usually the one who gets to spend the money at its full purchasing power.

The Second Layer:

The second layer of people is comprised of people that the government has made these payments to. They are now in possession of this newly created money which has not got fully circulated in the economy. As a result, there is a time lag in the rising of prices. At this stage, the prices must have risen a little, however not to a great extent. It is for this reason that the people who spend the money at this stage have a lesser purchasing power than the government but still have a higher purchasing power as compared to lower layers.

The Last Layer:

Finally, the newly created money is used in several transactions. It is rolled over and over in the economy and its value has been largely absorbed. As a result of the newly created money, the prices have now increased and people in the last layer are getting the worst deal as far as purchasing power is concerned. This is because they have to make their purchase after the prices have risen.

This is when the poorest get paid. The last layer usually comprises of daily wage earners, salaried people and others. These people find that by the time, the money has reached them, the prices have already risen. Thus inflation is a method of systematically transferring purchasing power from the poor to the rich. The higher ups in the hierarchy barely feel the effects of inflation. The effects are borne by the poor masses!

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.