Depending on the rate, future expectations, economic situation and the duration of the inflation among others; inflation could increase the level of investment or fail to cause any changes at all. On this note, economists are of the view that a little amount of inflation is actually good for the economy. The Tobin-Mundell effect is one proposition that goes against the common notion of negative effects of inflation. The Tobin-Mundell effect maintains that expected high rates of inflation cause people to convert real money balances to tangible capital.
Major setbacks to private capital formation caused by high inflation rates include rise in interest rates, devaluation of currency as a result of fluctuations in foreign exchange and high variability of inflation. Outside the investment circles, inflation leads to sky-rocketing of prices of goods and services so that people spend more while saving less. The effect of this is a reduction in investment undertakings in the capital market. As this paper will reveal, the effects of inflation on private investment depends on rate of inflation, duration of inflation and future predictions and expectations in the capital markets.
How different investors react to these factors is however different so that effects of inflation on private capital formation are often labeled ambiguous. This paper explores the various facets of inflation with a view of establishing its effects on private capital formation. Resulting macroeconomic effects of inflation are discussed while relating each to private capital formation to show how effects on the latter bring themselves out. Analysis The mention of inflation, usually referred as the "I" word in the investment world is bound to cause a series of ripples and mixed reactions.
Usually dreaded for its negative effects on private capital formation, inflation is characterized by among others high prices of goods, increases in interest rates, currency devaluation and general destabilization in the capital market (De Gregrio, 2). Inflation occurs when too few goods are being pursued by excess demand (Elvienna, 97). This could be as a result of increased money supply or as a result of sudden fall in supply of goods and services. Fall in the level of supply is also causes inflation.
The question that comes to mind now is how private capital formation is affected when inflation occurs. Private capital formation which is the transfer of private savings into the commercial sector comes about through investment activities made by the private sector (Smith, 196). These activities as this paper reveals could be affected by inflation either in a positive way or in a negative way. The effects of inflation are highly dependent on the rates of inflation. Elvienna (99) notes that it is possible for investment to be enhanced or sustained under certain levels of inflation.
Inflation levels that are low or moderate indicate macroeconomic stability (Smith, 187). A stable economy encourages investment in the country so that private capital formation is enhanced. While most scholars have conveniently concluded that inflation only brings negative effects, a few studies that indicated otherwise. The Tobin-Mundell suggests that inflation has no real effects on investments since investors respond by transferring their money balances to physical assets such that they may not lose anything (Agenor, 62).
The negative wealth effect is also put forth and this maintains that inflation causes people to save more so as to spare money for the uncertain future (Agenor, 67). It is because of these mixed effects and different reactions by investors that Agenor (62) concedes that inflation effects on investment are ambiguous. Since we would be more interested in preventing negative effects of inflation on private capital formation, it is best that negative effects are discussed first. Furthermore, this study reveals that most of the positive effects only benefit a few investors such that not much capital is formed after all.
Again, since the effects on private capital formation stem directly from the effects brought about in the economy by inflation it is best that the study be based on these effects which will then be related to private capital formation. The next portion of the paper will illustrate these effects. Negative Effects Increase in Prices of goods Relative price distortions result when an economy is not fully adjusted to the economy. In the case of inflation, presence of excess demand as opposed to the level of supply leads to sudden increases in the price level for goods and services (Akerlof, 12).
This follows the law of demand and supply which denotes that high demand leads to higher prices. High demand results from increase in cash balances available to consumers probably from increased income or availability of credit (Thadden, 6). As more is demanded and less is supplied, producers tend to increase their prices to take advantage of the increase in supply. As will be discussed later, this is an advantage to traders who may actually make money in the short-run more so if they had a stock of previously purchased goods. This however eventually fades away and they have to contend with the overall increases in prices leading to losses.
Increases in prices of goods affect investment in two major ways: one is the reduction in the value of money while the other is the increase in interest rates as a result of government borrowing to offset deficit budgets (Smith, 156). Both of these are discouraging to investment in their own special way. Decreased Value of money Inflation causes prices of goods to rise without any addition of value (Smith, 156). The value of money is said to have reduced because the same amount of money is used to purchase less (Yatrakis, 231).
Consequently, private investors have to spend more in order to obtain goods and services which raises production costs. High costs of production on the other hand discourages investment so that potential investors fail to commit their finances while existing firms may close down (Yatrakis, 233). Increase in prices pose a major threat to international firms producing locally by reducing their competitive advantage (Willey, 308). As prices of raw materials increase, production costs increase as well. This could necessitate the increase in prices for sustainable profit purposes.
Considering that competitors in the international market are not being faced by the problem of inflation in their countries, their prices remain constant. Local firms may then be forced to quit since they cannot effectively compete in the international arena (Willey, 309). Increased Government borrowing The rise in prices of goods affects the government budget such that a deficit is recorded (Kanth, 69). This stems directly from the fact that the increased prices cause strain in government expenditures so the revenues set aside for the fiscal year are not enough to cater for the current expenses.
The government therefore resorts to borrowing either through taxes or from external sources (Kanth, 73). The effect of high fiscal deficits is that the rates of interest also go up and a direct impact on cost of capital in the market is felt (Nabende and Slater, 4). This concept will be further discussed under interest rates and cost of capital section. Effect on exchange rates With increase in inflation, the country's currency as opposed to other currencies could lose its value (Elveinna, 103). Private investment is deterred by a devalued currency as it is likely to increase the cost of imported goods.
These are goods that investors probably need for the production of other goods and services within the country or for re-sale. Increased costs of goods raises prices which could reduce their demand such that profits are restricted (Pindyk and Solimano, 267). This discourages investors since they are not making proper returns. They may therefore decide to move to more favorable countries or stop production all the same. This could be disastrous to the economy as a result of reduction in capital formation. The burden of debt rises whenever devaluation of the currency occurs (Smith, 136).
As a result, the net worth of businesses reduces such that they cannot easily access credit facilities. The rising burden of debt also raises the cost of capital such that investment capability is reduced (Willey, 134). Rise in Interest rates and Cost of capital The level of interest rates in the economy at any given time are bound to cause turbulence in the economy. One of these effects is the reduction in investment returns leading to a reduction in propensity to invest (Smith, 139). High inflation levels lead to an increase in interest rates so that they often lead to harmful effects on the private capital formation (Kanth, 78).
Capital formation is not only determined by profits and savings but to a large extent depends on the expansion and availability of credit (Kanth, 79). Credit helps to speed up the process of capital formation since investors can access lump sum finances more easily than they can access through savings and profits. These financial advances therefore ensure that more investment can be made leading to more capital formation. This is the reason why credit institutions such as banks and non-financial institutions play such an invaluable role in private capital development (Sundararajan and Thakur, 23).
Their inability to provide the much needed capital expansion to the private sector as a result of inadequate funds is therefore a major set back to private capital formation. It is therefore quite unfortunate that inflation causes this kind of shortage in available money balances leading to high costs of capital which negatively affects investment. Rising cost of capital emerges as a result of increase in rates of interest and government monetary policy aimed at reducing the levels of inflation in the country (Fry, 224).