Journal of Economics and Sustainable Development www.iiste.org ISSN 2222-1700 (Paper) ISSN 2222-2855 (Online) Vol.4, No.20, 2013 148 The Effects of Chronic Inflation on Resource Allocation: towards understanding non-neutrality of monetary inflation Alhaji Bukar Mustapha 1 * Masoud Ali Khalid 2 1. Department of Economics, University of Maiduguri, P.M.B 1069, Maiduguri, Nigeria 2. Department of Economics, University of Human Development (UHD), Kurdistan, Sulaiymani, Iraq. * E-mail of the corresponding author: abmustaphaalibe@yahoo.com Abstract This paper attempts to provide an in-depth discussion on the ways in which chronic inflation distorts efficient allocation of resources in an economy. The rate of inflation in some developing countries has been high and volatile, and the rate of adjustment of the nominal variables is quite low both in the short and long-run. The process of adjustments is not only low but also less systematic thereby adversely affects contracts denominated in money and money terms. The study also highlights some likely distortions arising from anti-inflationary measures such as usury laws and other state controls, and their likely impacts on long-term finance and implications for rate of urban development in less developed countries. However, the study concludes that monetary inflation is non-neutral on resource allocation as it erodes the real value of money and monetary assets. Therefore, we recommend that given the severity of the distortions and its associated costs there is the need for an effective monetary correction mechanism. Keywords: Inflation, monetary contracts, non-neutrality of money, Resource allocation 1. Introduction Inflation is non-neutral in the sense that allocation of resources is different where there is inflation than when there is none. Inflation is literally defined as a continual rise in the price level. The price level is an index of all prices in the economy (Colander, 2004). Thus, the purchasing power of money declines during inflationary periods because each unit of currency buys progressively a smaller amount of goods. Therefore, high inflation largely influences the behaviour of individuals in creating money contracts of various types. Many contracts in monetary terms are either fixed or unable to adjust sufficiently promptly to reflect the increase in the price level and cause them to undergo a decline in their real values. One of the most important reasons for this concern is the financial market as both short and long term contracts denominated in money may not simply adjust spontaneously to take account of the changes in the price level. This paper makes an attempt to examine theoretically the main ways in which monetary inflation is non-neutral on resource allocation and why do various contracts denominated in money do not simply adjust spontaneously to take account of the new price level and, is the problem simply a short-term adjustment problem or can the distortions be long-lasting. The essay is divided into three sections. The following section discusses the conceptual and theoretical underpinnings concerning the subject. The final section provides the conclusion and practical implications. 2. Conceptual and theoretical discussions One of the fundamental propositions of the monetary economics is that money is neutral to the real economic phenomenon. The real question is whether inflation affects the structure of relative prices, output and employment. It is indeed the classical paradigm of the quantity theory, which argued that a change in the quantity of nominal money causes the price level to change proportionately, while real variables such as real interest rates, output and employment remain unchanged. Fisher (1930) raised the concept of “money illusion” to elucidate for the short -run effect of money arising from changes in real interest rates. The short-run non-neutrality of money is an important feature in the Keynesian monetary theory. It is based on the contention that under the conditions of underemployment the price level does not increase in the same proportion to the increase in the quantity of money. Therefore resulting increase in the quantity of money reduces the interest rate and hence increases investment and real output. The monetarists argue that in the short-run the impact of money is non-neutral on the real economy's output but in the long-run (which is over decades) affects mainly prices. However, the level of output in the long run is not influenced by