Inflation differential, effects

Effects of Differential Inflation Inflation can be general or differential. In the first case, all costs and prices increase at a uniform rate. In the second, government controls and other factors cause the various costs and prices to inflate at different rates. 

Let us consider the effect of differential inflation on the overall profitability of the project of the last example. The effect of general inflation on this project showed that the apparent profitability rises sharply, to an (NPV) of 431,269 at a general inflation rate of 20 percent. However, when the cash flows of the (NPV) are properly corrected to their purchasing power in Year 0, the (NPV) instead becomes 208,733. 

The effect of differential inflation on this project emerges in Fig. 9-35, with all (NPV)s corrected to their purchasing power in Year 0. The top line shows (NPV) for various rates of general inflation. The bottom line shows (NPV) for the differential-inflation case in which only the costs are allowed to increase while product selling price and thus cash income remain constant from year to year. The middle hne shows the effect of general inflation when the price rises are delayed by I year. The figure confirms that both of these situations take away from the attractiveness of the project. 

FIG. 9-35 Effect of differential inflation on inflation-corrected net present value. 

The effect upon total taxes paid, when they are corrected to their purchasing power in Year 0, is shown in Fig. 9-36. Differential inflation not only decreases the profitability of the project to its owner but also decreases the revenue received by the taxing authority. The method of calculation is identical to that of the earlier example. 

A topical aspect of differential inflation is the question of energy costs. Will the cost of a particular fuel rise or fall in relation to prices in general, and if so, what effect will this have on the economics of a project ... 

Define actual dollars as cash flows that incorporate the effects of inflation. These may be viewed as out-of-pocket dollars because they are the true expenses paid or revenues received in business transactions at any point in time. Unfortunately, a common terminology does not exist for differentiating dollars, as actual dollars are often referred to as current, nominal, future, or inflated dollars. 

We have assumed that the price rise due to the excess demand in L is transferred to B in spite of the declining demand in this market. This means that B reacts to the Declining Differentiated Demand (D3) by quantity adjustment rather than by price adjustment. Excess capacity and unemployment will thus be generated in B. Thus as a result of the Income Redistribution Effect (IRE) of inflation we get an inflation which not only naturally coexists with recession but necessarily generates and sustains itself as well as recession. It follows from the same mechanism that the dominant effect of the demand shift is a change in the general price level and not in the relative prices in the two markets. We therefore assume only one general price level in the economy (p) which measures the overall inflation. 

The final result of the Double-Effect of the Differentiated-Excess-Demand (DED) is the appearance of inflation accompanied by recession. The feedback of the price-rise on income re-distribution (IRE) and the link of the latter to demand shift, turns that phenomenon into a stagflationary spiral. 

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