Inflation (that is, the counterfeiting of money by the government) has several destructive effects on the economy. It transfers wealth from late recipients of newly issued monetary units to those who receive them relatively earlier. It hurts the ability of economic actors to perform economic calculation. It degrades the quality of goods and services produced in the economy. Furthermore, it causes boom and bust cycles in the economy.
Wealth Redistribution
The overall effect of the introduction of new monetary tokens is a general increase in price levels. But this effect is neither smooth nor instantaneous. Not everyone acquires an equal amount of these tokens, or at the same time. Also, not all prices rise proportionately, or at the same time.
The early recipients of these tokens are able to buy goods and services at prevailing rates. Those they transact with, similarly, are able to conduct economic activities without experiencing a rise in prices. However, as the tokens spread throughout the economy, people start bidding up the prices: after all, there are more monetary tokens than earlier but the stock of goods and services are at the same level. Those who receive these tokens later, that is after the price levels of the goods and services they wish to purchase, suffer. Effectively, this is a wealth transfer from late receivers to the early receivers.
In the current economy, government contractors, subsidy recipients, corporate entities capable of borrowing large amounts at low rates, are the early receivers. In the middle are common businesses that, in response to rising input costs, can increase the prices of the goods and services they sell. Recipients of salary, pensioners, bond holder and so on, are at the end, losing the most.
Economic Miscalculations
While inflation is taking place, it is impossible to distinguish a transitional rise in price from a permanent one. As a result, individuals and businesses budget inappropriately. Businesses set aside too little for the replacement of capital goods and end up overestimating profits. Stock and bond holders also overestimate their real gains. Due to illusory profits, economic actors end up consuming a part of their capital without meaning to.
Quality Degradation
Because consumers are more sensitive to nominal price increases, to preserve profits, businesses have to lower the quality of their offerings. Ingredients are replaced with cheaper alternatives, services are reduced, and even the quantity of goods in packages is reduced. The overall quality of goods and services in the economy falls.
Business Cycles
Inflation is responsible for boom and bust cycles. Illusory profits and access to cheap loans incentivize businesses to expand production, hire more labor, and borrow more. More businesses enter the industry. But after the permanent price rises become apparent, many of these investments are revealed to be malinvestments. They are forced to halt expansion, which leads to capital destruction in many cases. They are forced to lay off workers, leading to mass unemployment. Several businesses, unable to meet their debt obligations, are forced to exit the market. The injection of monetary tokens causes a cycle of exuberance and capital misallocation followed by capital destruction and mass misery.
References
- Rothbard, Murray. What Has Government Done To Our Money? Chapter 2.