- Inflation, or the gradual increase in the price of goods and services over time, has a variety of positive and negative consequences.
- Inflation reduces purchasing power, or the amount of something that can be bought with money.
- Because inflation reduces the purchasing power of currency, customers are encouraged to spend and store up on products that depreciate more slowly.
What are the consequences of inflation?
Inflation has the following negative macroeconomic repercussions in addition to rising consumer costs, which disproportionately affect low-income households:
1. Interest rates that are higher.
In the long run, inflation leads to higher interest rates. When the government expands the money supply, interest rates fall at first because there is more money available. However, the increasing money supply causes higher equilibrium prices and a decreased value of money, causing banks and other financial institutions to hike rates to compensate for the loss of purchasing power of their funds. Higher long-term rates deter corporate borrowing, resulting in lower capital goods and technology investment.
2. A decrease in exports.
Higher goods costs suggest that other countries will find it less appealing to buy our products. This will result in a drop in exports, decreased output, and increased unemployment in our country.
3. Less money saved.
Inflation pushes people to spend instead of save. People are more likely to buy more things now, before they become more expensive later. They discourage people from saving since money saved for the future will be worth less. Savings are required to raise the amount of money available in the financial markets. This enables companies to borrow money to invest in capital equipment and technology. Long-term economic growth is fueled by advances in technology and capital goods. Inflation encourages people to spend more, which discourages saving and inhibits economic progress.
Malinvestments are number four.
Inflation leads to poor investing decisions. When prices rise, the value of some investments rises more quickly than the value of others. Prices of existing houses, land, gold, silver, other precious metals, and antiques, for example, rise when inflation rises. During periods of rising inflation, more money is invested in these assets than in other, more productive assets. These assets, on the other hand, are existing assets, and investing in them does not expand our nation’s wealth or employment. Rather than investing in businesses that generate new wealth, monies are diverted to assets that do not add to the country’s economic capability. Because of shifting inflation, investing in productive and innovative business operations is risky. An investor planning to spend $2 million in a new business anticipates a specific return. If, for example, inflation is 12%, the rate of return must be at least that, or the investor will lose real income. If the investor is concerned that he or she will not be able to return at least 12 percent on the investment, the new firm will not be started.
Furthermore, while present property owners may benefit from an increase in the value of their properties, current property buyers suffer. Current customers pay exaggerated prices for land, housing, and other goods. Some workers who may have bought a home ten or fifteen years ago are unable to do so now.
5. Government spending that is inefficient.
When the government uses newly issued money to support its expenditures, it simply collects the profits made by the Federal Reserve System on the newly printed money. Free money is not spent as wisely or efficiently as money earned via greater hardship, according to experience. There is a level of accountability when the government raises taxes to raise revenue. There is no accountability when the government obtains funding through newly minted money until citizens become aware of the true cause of inflation.
6. Increases in taxes.
Taxes rise in response to rising prices. Nominal (rather than actual) salaries rise in tandem with inflation, pushing higher-income individuals into higher tax rates. Despite the fact that purchasing power does not improve, a person pays the government a larger portion of his or her income. Houses, land, and other real estate are all subject to higher property taxes. Tax rates will remain constant if the government modifies the brackets in lockstep with inflation; unfortunately, the government sometimes fails to adjust the brackets, or just partially adjusts them. Higher tax rates will result as a result of this.
Why do governments (more precisely, central banks, or in the United States, the Federal Reserve) continue to print money and induce inflation, despite the risks? This can be explained in a number of ways. The ability to print money provides governments with unrestricted access to funds. Every year, the Federal Reserve prints billions of dollars and distributes them to the general government, which spends the money on various products. Furthermore, printing money can stimulate the economy in the near run because an increase in the money supply decreases short-term interest rates. Many individuals (especially politicians, because elections occur regularly) favor short-term rewards over long-term ones in our age of immediate gratification.
Another benefit of inflation (for the government) is that it raises nominal wages and pushes people into higher tax rates if tax brackets are not fully adjusted (see harmful effect 6 above). Increased taxes equal more income for the government (and people won’t blame politicians for higher taxes if they don’t understand why inflation is occurring).
Finally, borrowers who have borrowed money benefit from inflation because they may repay their loans in deflated dollars. Governments are the greatest borrowers in most economies, so they have a vested interest in keeping inflation high. People who save, on the other hand, have the opposite problem (mostly private citizens that save and people that try to build up a pension). Inflation reduces the value of future savings, putting many ordinary persons at a disadvantage. Financial markets are also damaged (see adverse effect 3 above), as less funds are accessible in the financial markets as savings decline (i.e. less money for research and development, business expansions, etc.).
Is inflation beneficial or harmful to the economy?
- Inflation, according to economists, occurs when the supply of money exceeds the demand for it.
- When inflation helps to raise consumer demand and consumption, which drives economic growth, it is considered as a positive.
- Some people believe inflation is necessary to prevent deflation, while others say it is a drag on the economy.
- Some inflation, according to John Maynard Keynes, helps to avoid the Paradox of Thrift, or postponed consumption.
Who is the most vulnerable to inflation?
Inflation is defined as a steady increase in the price level. Inflation means that money loses its purchasing power and can buy fewer products than before.
- Inflation will assist people with huge debts, making it simpler to repay their debts as prices rise.
Losers from inflation
Savers. Historically, savers have lost money due to inflation. When prices rise, money loses its worth, and savings lose their true value. People who had saved their entire lives, for example, could have the value of their savings wiped out during periods of hyperinflation since their savings became effectively useless at higher prices.
Inflation and Savings
This graph depicts a US Dollar’s purchasing power. The worth of a dollar decreases during periods of increased inflation, such as 1945-46 and the mid-1970s. Between 1940 and 1982, the value of one dollar plummeted by 85 percent, from 700 to 100.
- If a saver can earn an interest rate higher than the rate of inflation, they will be protected against inflation. If, for example, inflation is 5% and banks offer a 7% interest rate, those who save in a bank will nevertheless see a real increase in the value of their funds.
If we have both high inflation and low interest rates, savers are far more likely to lose money. In the aftermath of the 2008 credit crisis, for example, inflation soared to 5% (owing to cost-push reasons), while interest rates were slashed to 0.5 percent. As a result, savers lost money at this time.
Workers with fixed-wage contracts are another group that could be harmed by inflation. Assume that workers’ wages are frozen and that inflation is 5%. It means their salaries will buy 5% less at the end of the year than they did at the beginning.
CPI inflation was higher than nominal wage increases from 2008 to 2014, resulting in a real wage drop.
Despite the fact that inflation was modest (by UK historical norms), many workers saw their real pay decline.
- Workers in non-unionized jobs may be particularly harmed by inflation since they have less negotiating leverage to seek higher nominal salaries to keep up with growing inflation.
- Those who are close to poverty will be harmed the most during this era of negative real wages. Higher-income people will be able to absorb a drop in real wages. Even a small increase in pricing might make purchasing products and services more challenging. Food banks were used more frequently in the UK from 2009 to 2017.
- Inflation in the UK was over 20% in the 1970s, yet salaries climbed to keep up with growing inflation, thus workers continued to see real wage increases. In fact, in the 1970s, growing salaries were a source of inflation.
Inflationary pressures may prompt the government or central bank to raise interest rates. A higher borrowing rate will result as a result of this. As a result, homeowners with variable mortgage rates may notice considerable increases in their monthly payments.
The UK underwent an economic boom in the late 1980s, with high growth but close to 10% inflation; as a result of the overheating economy, the government hiked interest rates. This resulted in a sharp increase in mortgage rates, which was generally unanticipated. Many homeowners were unable to afford increasing mortgage payments and hence defaulted on their obligations.
Indirectly, rising inflation in the 1980s increased mortgage payments, causing many people to lose their homes.
- Higher inflation, on the other hand, does not always imply higher interest rates. There was cost-push inflation following the 2008 recession, but the Bank of England did not raise interest rates (they felt inflation would be temporary). As a result, mortgage holders witnessed lower variable rates and lower mortgage payments as a percentage of income.
Inflation that is both high and fluctuating generates anxiety for consumers, banks, and businesses. There is a reluctance to invest, which could result in poorer economic growth and fewer job opportunities. As a result, increased inflation is linked to a decline in economic prospects over time.
If UK inflation is higher than that of our competitors, UK goods would become less competitive, and exporters will see a drop in demand and find it difficult to sell their products.
Winners from inflation
Inflationary pressures might make it easier to repay outstanding debt. Businesses will be able to raise consumer prices and utilize the additional cash to pay off debts.
- However, if a bank borrowed money from a bank at a variable mortgage rate. If inflation rises and the bank raises interest rates, the cost of debt repayments will climb.
Inflation can make it easier for the government to pay off its debt in real terms (public debt as a percent of GDP)
This is especially true if inflation exceeds expectations. Because markets predicted low inflation in the 1960s, the government was able to sell government bonds at cheap interest rates. Inflation was higher than projected in the 1970s and higher than the yield on a government bond. As a result, bondholders experienced a decrease in the real value of their bonds, while the government saw a reduction in the real value of its debt.
In the 1970s, unexpected inflation (due to an oil price shock) aided in the reduction of government debt burdens in a number of countries, including the United States.
The nominal value of government debt increased between 1945 and 1991, although inflation and economic growth caused the national debt to shrink as a percentage of GDP.
Those with savings may notice a quick drop in the real worth of their savings during a period of hyperinflation. Those who own actual assets, on the other hand, are usually safe. Land, factories, and machines, for example, will keep their value.
During instances of hyperinflation, demand for assets such as gold and silver often increases. Because gold cannot be printed, it cannot be subjected to the same inflationary forces as paper money.
However, it is important to remember that purchasing gold during a period of inflation does not ensure an increase in real value. This is due to the fact that the price of gold is susceptible to speculative pressures. The price of gold, for example, peaked in 1980 and then plummeted.
Holding gold, on the other hand, is a method to secure genuine wealth in a way that money cannot.
Bank profit margins tend to expand during periods of negative real interest rates. Lending rates are greater than saving rates, with base rates near zero and very low savings rates.
Anecdotal evidence
Germany’s inflation rate reached astronomical levels between 1922 and 1924, making it a good illustration of high inflation.
Middle-class workers who had put a lifetime’s earnings into their pension fund discovered that it was useless in 1924. One middle-class clerk cashed his retirement fund and used money to buy a cup of coffee after working for 40 years.
Fear, uncertainty, and bewilderment arose as a result of the hyperinflation. People reacted by attempting to purchase anything physical such as buttons or cloth that might carry more worth than money.
However, not everyone was affected in the same way. Farmers fared handsomely as food prices continued to increase. Due to inflation, which reduced the real worth of debt, businesses that had borrowed huge sums realized that their debts had practically vanished. These companies could take over companies that had gone out of business due to inflationary costs.
Inflation this high can cause enormous resentment since it appears to be an unfair means to allocate wealth from savers to borrowers.
What are the effects of inflation on businesses?
Inflation decreases money’s buying power by requiring more money to purchase the same products. People will be worse off if income does not increase at the same rate as inflation. This results in lower consumer spending and decreased sales for businesses.
What is the state of inflation in the United States?
The core inflation rate, which is commonly measured on a year-over-year basis, eliminates the influence of volatile oil and food prices. In February 2022, it was growing 6.4 percent annually and 0.5 percent. 1 That’s substantially more than the Federal Reserve’s recommended objective of 2% to keep the economy healthy.
Is inflation equally harmful to everyone?
Inflation is on the rise. It does not have the same effect on everyone. Rising costs, according to economists, can have a disproportionate impact on low-income households. However, as NPR’s Laurel Wamsley tells, incomes at the bottom of the pay range are also rising.
What is creating 2021 inflation?
As fractured supply chains combined with increased consumer demand for secondhand vehicles and construction materials, 2021 saw the fastest annual price rise since the early 1980s.
Is inflation beneficial to debtors?
Inflation, by definition, causes the value of a currency to depreciate over time. In other words, cash today is more valuable than cash afterwards. As a result of inflation, debtors can repay lenders with money that is worth less than it was when they borrowed it.
What three impacts does inflation have?
Inflation lowers your purchasing power by raising prices. Pensions, savings, and Treasury notes all lose value as a result of inflation. Real estate and collectibles, for example, frequently stay up with inflation. Loans with variable interest rates rise when inflation rises.
What effect does inflation have on profitability?
In general, businesses favor modest and stable inflation. Firms may face higher costs and uncertainties if inflation increases above 3 or 4 percent. Inflation can entail a rise in expenses, a drop in profitability, and a loss of worldwide competitiveness for businesses.
Inflation, on the other hand, isn’t always bad for businesses, especially if they can raise prices to customers faster than their production costs grow.
- The price of the menu. These are the expenses associated with altering pricing lists. Firms will have to alter prices more frequently if inflation is significant. This has a price tag attached to it. High inflation could be particularly destructive to businesses like Pound/Dollar shops, as it becomes more difficult to obtain things that can be offered for a Pound.
- Modern technology, on the other hand, makes adjusting prices much easier than before. You no longer need to alter pricing manually; instead, you may update barcodes, which takes less time.
- Wage Inflation is a term that is used to describe the increase in the value Unexpected inflation may necessitate renegotiating compensation agreements with employees. These salary increases, however, may be too expensive for the company.
- Uncertainty and perplexity. If inflation is more than projected, investment costs will fluctuate often. Firms are less eager to spend as a result of uncertainty about future costs, wages, and demand. This is especially problematic when unexpected cost-push inflation drives up the cost of raw materials. High inflation increases uncertainty and can lead to poorer growth, which is likely the most significant cost of inflation for businesses.
- Competitiveness on the global stage. If the UK’s inflation rate is higher than that of other countries, UK businesses will be less competitive against overseas competitors; this is critical for exporters.
- A higher rate of inflation than our competitors will result in a depreciation in the exchange rate, which will assist to restore competitiveness but at the cost of increased import prices and a drop in living standards.
If the inflation is unanticipated, the costs of inflation will be even higher. For example, if firms estimate inflation to be 2% but it turns out to be 5%, the situation is worse than if they had expected inflation to be 5%.
Cost-push inflation is one of the most difficult types of inflation for businesses to deal with. This is inflation caused by a rise in the cost of raw resources, yet demand is falling at the same time. As a result, businesses are facing increased prices as well as decreasing demand. As a result, businesses are frequently forced to reduce profit margins and endure price hikes.
Benefits of inflation for firms
- Reduces the debt’s worth. If a company is in debt, inflation may assist diminish the debt’s true value. This is because nominal revenue will rise due to inflation, making it simpler to repay past debts. In this situation, inflation is preferable to deflation, which would result in a rise in the real worth of debt.
- However, interest rates play a role. Firms with debt will face growing interest rate charges if high inflation leads to high interest rates.
- Strong economic growth is frequently accompanied by modest inflation. Assume inflation is very low, say 0.5 percent, which is most likely related with slow economic development. Higher prices and economic growth will result from a demand stimulation. In this situation, increased inflation may result in a boost in corporate profitability.
- Inflation that is moderate makes it easier to modify relative prices and salaries. Inflation of 0%, for example, makes it difficult to reduce nominal salaries for unproductive workers. When inflation is below 2%, however, it is easier to implement pay freezes and actual wage cuts for unproductive personnel.
How does inflation affect the profits of a firm?
With increased economic growth, the firm will experience rising demand and will be able to raise prices in a period of demand-pull inflation. It may be able to increase profits in this case, at least in the short term. However, if inflationary expansion leads to a boom and bust, a recession with lower demand and profits may follow.
It depends on whether enterprises are able to pass on growing production costs to consumers during a period of cost-push inflation. Firms may be under pressure to absorb cost increases by cutting profit margins if markets are highly competitive and demand is poor.
In the long run, a low inflationary environment may encourage increased investment and demand, resulting in larger profits.
Example of Cost-push inflation from depreciation
The value of the pound in the UK fell 15% in 2016 as a result of the Brexit vote. Import prices rose as a result of the depreciation. Input prices increased for businesses.
Despite increasing inflation, employers were able to maintain minimal wage growth. Wages dropped in real terms. As a result, workers felt the effects of inflation more than businesses.
Firms must wait a certain amount of time before passing on greater expenses to customers. However, businesses may endeavor to avoid raising prices.
Tesco has threatened to stop stocking products if manufacturers try to pass on higher import prices during this period of rising import prices. (See Tesco boss warns food producers against passing on devaluation to customers.)
In other words, Tesco (which has some buying power) is attempting to force food manufacturers to absorb input price increases and cut profit margins.
Consumers will likely applaud the action (and Tesco may benefit from the publicity), but will producers be able to absorb all of the input price hikes on their own?