Inflation is and has been a contentious topic in economics. Even the term “inflation” has diverse connotations depending on the situation. Many economists, businesspeople, and politicians believe that mild inflation is necessary to stimulate consumer spending, presuming that higher levels of expenditure are necessary for economic progress.
How Can Inflation Be Good For The Economy?
The Federal Reserve usually sets an annual rate of inflation for the United States, believing that a gradually rising price level makes businesses successful and stops customers from waiting for lower costs before buying. In fact, some people argue that the primary purpose of inflation is to avert deflation.
Others, on the other hand, feel that inflation is little, if not a net negative on the economy. Rising costs make saving more difficult, forcing people to pursue riskier investing techniques in order to grow or keep their wealth. Some argue that inflation enriches some businesses or individuals while hurting the majority.
The Federal Reserve aims for 2% annual inflation, thinking that gradual price rises help businesses stay profitable.
Understanding Inflation
The term “inflation” is frequently used to characterize the economic impact of rising oil or food prices. If the price of oil rises from $75 to $100 per barrel, for example, input prices for firms would rise, as will transportation expenses for everyone. As a result, many other prices may rise as well.
Most economists, however, believe that the actual meaning of inflation is slightly different. Inflation is a result of the supply and demand for money, which means that generating more dollars reduces the value of each dollar, causing the overall price level to rise.
Key Takeaways
- 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.
When Inflation Is Good
When the economy isn’t operating at full capacity, which means there’s unsold labor or resources, inflation can theoretically assist boost output. More money means higher spending, which corresponds to more aggregated demand. As a result of increased demand, more production is required to supply that need.
To avoid the Paradox of Thrift, British economist John Maynard Keynes argued that some inflation was required. According to this theory, if consumer prices are allowed to decline steadily as a result of the country’s increased productivity, consumers learn to postpone purchases in order to get a better deal. This paradox has the net effect of lowering aggregate demand, resulting in lower production, layoffs, and a faltering economy.
Inflation also helps borrowers by allowing them to repay their loans with less valuable money than they borrowed. This fosters borrowing and lending, which boosts expenditure across the board. The fact that the United States is the world’s greatest debtor, and inflation serves to ease the shock of its vast debt, is perhaps most crucial to the Federal Reserve.
Economists used to believe that inflation and unemployment had an inverse connection, and that rising unemployment could be combated by increasing inflation. The renowned Phillips curve defined this relationship. When the United States faced stagflation in the 1970s, the Phillips curve was severely discredited.
Fixed-rate mortgage holders
According to Mark Thoma, a retired professor of economics at the University of Oregon, anyone with substantial, fixed-rate loans like mortgages benefits from increased inflation. Those interest rates are fixed for the duration of the loan, so they won’t fluctuate with inflation. Given that homes are regarded an appreciating asset over time, homeownership may also be a natural inflation hedge.
“They’re going to be paying back with depreciated money,” Thoma says of those who have fixed-rate mortgages.
Property owners will also be protected from increased rent expenses during periods of high inflation.
What are three advantages to inflation?
Inflationary Impacts Questions Answered Profits are higher because producers can sell at higher prices. Investors and businesses are rewarded for investing in productive activities, resulting in higher investment returns. Production will increase. There will be more jobs and a higher wage.
Advantages of Inflation
- Deflation has the potential to be exceedingly harmful to the economy, as it might result in fewer consumer spending and growth. When prices are falling, for example, buyers are urged to put off purchasing in the hopes of a lower price in the future.
- The real worth of debt is reduced when inflation is moderate. In a deflationary environment, the real value of debt rises, putting a strain on discretionary incomes.
- Inflation rates that are moderate allow prices to adjust and goods to reach their true value.
- Wage inflation at a moderate rate allows relative salaries to adjust. Wages are stuck in a downward spiral. Firms can effectively freeze pay raises for less productive workers with moderate inflation, effectively giving them a real pay cut.
- Inflation rates that are moderate are indicative of a thriving economy. Inflation is frequently associated with economic growth.
Disadvantages of Inflation
- Inflationary rates create uncertainty and confusion, which leads to less investment. It is said that countries with continuously high inflation have poorer investment and economic growth rates.
- Increased inflation reduces international competitiveness, resulting in less exports and a worsening current account balance of payments. This is considerably more troublesome with a fixed exchange rate, such as the Euro, because countries do not have the option of devaluation.
- Inflation can lower the real worth of investments, which can be especially detrimental to elderly persons who rely on their assets. It is, however, dependent on whether interest rates are higher than inflation.
- The real value of government bonds will be reduced by inflation. To compensate, investors will demand higher bond rates, raising the cost of debt interest payments.
- Hyperinflation has the potential to ruin an economy. If inflation becomes out of control, it can lead to a vicious cycle in which rising inflation leads to higher inflation expectations, which leads to further higher prices. Hyperinflation can wipe out middle-class savings and transfer wealth and income to people with debt, assets, and real estate.
- Reduced inflation costs. Governments/Central Banks must implement a deflationary fiscal/monetary policy to restore price stability. This, however, results in weaker aggregate demand and, in many cases, a recession. Reduced inflation comes at a cost: unemployment, at least in the short term.
When weighing the benefits and drawbacks of inflation, it’s vital to assess the sort of inflation at hand.
- It’s possible that cost-push inflation is simply a blip on the radar (e.g. due to raising taxes). As a result, this is a one-time issue that isn’t as significant as deep-seated inflation (e.g. due to wage inflation and high inflation expectations)
- Cost-push inflation, on the other hand, tends to lower living standards (short-run aggregate supply is shifted left). Cost-push inflation is also difficult to manage because a central bank cannot simultaneously cut inflation and boost economic growth.
- It also depends on whether or not inflation is expected. Many people, particularly savers, are more likely to lose out if inflation is significantly greater than expected.
Is inflation beneficial to stocks?
Consumers, stocks, and the economy may all suffer as a result of rising inflation. When inflation is high, value stocks perform better, and when inflation is low, growth stocks perform better. When inflation is high, stocks become more volatile.
Is inflation beneficial to business?
Businesses face higher raw material, manufacturing, and overhead costs when prices rise. While passing all expenses to consumers may appear to leave a business largely unscathed, in reality, businesses will absorb a portion, if not the majority, of the additional prices to avoid losing customers.
Consumers’ purchasing power erodes as inflation rises; in plain terms, they can now buy less products and services than they could previously. This means that enterprises will have decreased sales, lowering their total revenue.
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.
Where should I place my money to account for inflation?
“While cash isn’t a growth asset, it will typically stay up with inflation in nominal terms if inflation is accompanied by rising short-term interest rates,” she continues.
CFP and founder of Dare to Dream Financial Planning Anna N’Jie-Konte agrees. With the epidemic demonstrating how volatile the economy can be, N’Jie-Konte advises maintaining some money in a high-yield savings account, money market account, or CD at all times.
“Having too much wealth is an underappreciated risk to one’s financial well-being,” she adds. N’Jie-Konte advises single-income households to lay up six to nine months of cash, and two-income households to set aside six months of cash.
Lassus recommends that you keep your short-term CDs until we have a better idea of what longer-term inflation might look like.
Is it beneficial to be in debt during a period of hyperinflation?
Consider your weekly shopping budget to get a sense of how hyperinflation might affect people and the economy. Let’s say you regularly spend $220 per week on food for your household of four.
However, one month you walk to the shop and discover that the same amount of food costs $330. It’s up to $495 by the following month. What impact would increasing costs have on your life?
What Happens to Consumers During Hyperinflation?
If you have money in the bank, you’ll most likely utilize it to stock up on groceries. This would be a totally reasonable answer from you. With your money’ purchase power dwindling, it makes sense to spend them as soon as feasible.
However, with so many people buying additional food, store shelves would quickly be depleted. As desperate buyers paid more and more for whatever food they could get, these shortages would lead to even greater price increases.
If you’re already on a shoestring budget, things will get significantly worse. You’d have to make sacrifices in other areas to buy food if you didn’t have any money. You’d eliminate all luxury spending and even cut back on essentials like heating fuel.
What Happens to Savings During Hyperinflation?
You’d lose a lot of purchasing power if you didn’t spend all of your money straight soon. Soon, all of the money in your bank account won’t be enough to buy a basket of groceries.
If you’re retired, this will be even more of an issue. If you continue to work, your earnings will almost certainly increase to keep up with rising prices. If you’re retired, however, you’ll be trying to survive on savings that are becoming increasingly worthless.
After years of diligently saving for retirement, you’d discover that your savings were no longer sufficient to support you. To make ends meet, you’d have to drastically reduce your expenditures. If that didn’t work, you’d have to borrow money or ask family, friends, or charity for assistance.
What Happens to Debt and Loans During Hyperinflation?
If you’re already in debt, hyperinflation might be beneficial to you.
Let’s say you owe $50,000 on your school loans. The sum would remain the same, but the value of the dollars would diminish over time. The loan obligation that appears so large today could be worth less than a loaf of bread in the future.
That would be fantastic news for you, but it would be bad news for the bank that provided you with the loan. It would now consider your debt to be worthless.
The lender may attempt to compensate by boosting interest rates on new loans. However, in order to keep up with inflation, they would have to be raised so expensive that only a few individuals could afford them.
Furthermore, if consumers like you spent all of their savings, there would be no new money available to make loans with. The bank may possibly go out of business as a result of this and the decreased value of its current loans.
What Happens to Businesses During Hyperinflation?
Your bank wouldn’t be the only company in danger. Coffee shops, movie theaters, and barbershops in your neighborhood would all suffer. Their business would dry up if you and other consumers cut back on everything except fundamental needs.
Some of these businesses might eventually close. This would result in their employees losing their jobs, worsening their financial condition. If this happened to a large number of enterprises, the entire economy may implode.
Businesses that rely on imports would be the hardest hit. Let’s say your neighborhood coffee shop sources its beans from South America. As the value of the dollar declined, the price of those beans would rise.
Exporters would be the only enterprises that would prosper. Assume a local software company distributes its products across Europe. With the value of the dollar declining, its software would be less expensive than that of competitors from other countries.
Even better, the software firm would be compensated in euros. In relation to the dollar, those would be worth more and more over time.
What Happens to Stocks During Hyperinflation?
What’s good or bad for businesses affects their investors as well. If you have money in the stock market, this indicates that some of your stocks will suffer during hyperinflation. Others, on the other hand, would prosper.
In general, the value of your stocks would climb in tandem with the value of other assets. However, this would be irrelevant because each dollar would be worth less.
Stocks of companies that manufacture and sell fundamental items are likely to perform well. People would stockpile those things, resulting in higher earnings for the companies. Export-oriented companies’ stocks would also do nicely. Their stock prices would climb, and they might even increase dividends.
Companies that trade in luxuries, on the other hand, would suffer. People would have less money to spend on their goods and services if prices rose. The stocks of importers would suffer the most.
Overall, as long as you have a varied portfolio, your stock investments should be fine. Some of your stocks would lose value, but others would gain, balancing everything out.
What Happens to Real Estate During Hyperinflation?
If you buy a home or invest in real estate, your investment will almost certainly increase in value. People would take money out of the bank and invest it in assets that would maintain their worth better, such as real estate, as the dollar declined in value.
House prices would rise as well, because new houses would be more expensive to construct. To recoup their costs, the builders would have to sell them for a higher price. The rising worth of these residences would increase the value of yours as well.
If you had purchased real estate with a fixed-rate mortgage, you would have been much better off. Your mortgage payment would remain the same, but you’d be able to pay it off in depreciated currency. That would be a far better deal than trying to keep up with rising rent costs.
However, if you tried to buy a house, you would have difficulties. Not only would housing prices rise, but so would mortgage rates. You’d be eligible for a considerably smaller mortgage and may be unable to purchase a home at all.
And that’s presuming you could still get a loan from a bank. Remember that if hyperinflation becomes severe enough, lenders may be forced to close their doors. Home purchasers and other borrowers are out of luck as a result.
What Happens to Government Spending During Hyperinflation?
The government would no longer be able to collect taxes from failing enterprises across the sector. Individuals would also contribute less since an increasing number of people would be unemployed. It would have less tax money to cover all of its bills as a result.
It may try to make up for the shortfall by printing additional money. However, this would exacerbate the inflation situation.
The only other option is for it to cease delivering essential services. People would no longer be able to collect their Social Security benefits. Medicare and Medicaid would no longer cover health-care costs. The mail would no longer be delivered by the post office. All of this would exacerbate the hardships already experienced by those who were already struggling.
Governments seek inflation for what reason?
Question from a reader: Why does inflation make it easier for governments to repay their debts?
During the 1950s, 1960s, and 1970s, when inflation was quite high, the national debt as a percentage of GDP dropped dramatically. Deflation and massive debt characterized the 1920s and 1930s.
Inflation makes it easier for a government to pay its debt for a variety of reasons, especially when inflation is larger than planned. In conclusion:
- Nominal tax collections rise as inflation rises (if prices are higher, the government will collect more VAT, workers pay more income tax)
- Higher inflation lowers the actual worth of debt; bondholders with fixed interest rates will see their bonds’ real value diminish, making it easier for the government to repay them.
- Higher inflation allows the government to lock income tax levels, allowing more workers to pay higher tax rates thereby increasing tax revenue without raising rates.
Why inflation can benefit the government at the expense of bondholders
- Let’s pretend that an economy has 0% inflation and that people anticipate it to stay that way.
- Let’s say the government needs to borrow 2 billion and sells 1,000 30-year bonds to the private sector. The government may give a 2% annual interest rate to entice individuals to acquire bonds.
- The government will thereafter be required to repay the full amount of the bonds (1,000) as well as the annual interest payments (20 per year at 2%).
- Investors who purchase the bonds will profit. The bond yield (2%) is higher than the inflation rate. They get their bonds back, plus interest.
- Assume, however, that inflation of 10% occurred unexpectedly. Money loses its worth as a result of this. As prices rise as a result of inflation, 1,000 will buy fewer products and services.
- As salaries and prices rise, the government will receive more tax money as a result of inflation (for example, if prices rise 10%, the government’s VAT receipts will rise 10%).
- As a result, inflation aids the government in collecting more tax income.
- Bondholders, on the other hand, lose out. The government still owes only 1,000 in repayment. However, inflation has lowered the value of that 1,000 bond (it now has a real value of 900). Because the inflation rate (ten percent) is higher than the bond’s interest rate (two percent), their funds are losing actual value.
- Because of inflation, repaying bondholders needs a lesser percentage of the government’s overall tax collection, making it easier for the government to repay the original loan.
As a result of inflation, the government (borrower) is better off, whereas bondholders (savers) are worse off.
Evaluation (index-linked bonds)
Some bondholders will purchase index-linked bonds as a result of this risk. This means that if inflation rises, the maturity value and interest rate on the bond will rise in lockstep with inflation, protecting the bond’s real value. The government does not benefit from inflation in this instance since it pays greater interest payments and is unable to discount the debt through inflation.
Inflation and benefits
Inflation is expected to peak at 6.2 percent in 2022 in the United Kingdom, resulting in a significant increase in nominal tax receipts. The government, on the other hand, has expanded benefits and public sector salaries at a lower inflation rate. In April 2022, inflation-linked benefits and tax credits will increase by 3.1%, as determined by the Consumer Price Index (CPI) inflation rate in September 2021.
As a result, public employees and benefit recipients will suffer a genuine drop in income their benefits will increase by 3.1 percent, but inflation might reach 6.2 percent. The government’s financial condition will improve in this case by increasing benefits at a slower rate than inflation.
Only by making the purposeful decision to raise benefits and wages at a slower rate than inflation can debt be reduced.
Inflation and bracket creep
Another approach for the government to benefit from inflation is to maintain a constant income tax level. The basic rate of income tax (20%), for example, begins at 12,501. At 50,000, the tax rate is 40%, and at 150,000, the tax rate is 50%. As a result of inflation, nominal earnings will rise, and more workers will begin to pay higher rates of income tax. As a result, even though the tax rate appears to be unchanged, the government has effectively raised average tax rates.
Long Term Implications of inflation on bonds
People will be hesitant to buy bonds if they expect low inflation and subsequently lose the real worth of their savings due to high inflation. They know that inflation might lower the value of bondholders’ money.
If bondholders are concerned that the government will generate inflation, greater bond rates will be desired to compensate for the risk of losing money due to inflation. As a result, the likelihood of high inflation may make borrowing more onerous for the government.
Bondholders may not expect zero inflation; yet, bondholders are harmed by unexpected inflation.
Example Post War Britain
Inflation was fairly low throughout the 1930s. This is one of the reasons why individuals were willing to pay low interest rates for UK government bonds (in the 1950s, the national debt increased to over 230 percent of GDP). Inflationary effects lowered the debt burden in the postwar period, making it simpler for the government to satisfy its repayment obligations.
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.
Inflation helped to expedite the decline of UK national debt as a percentage of GDP in the postwar period, lowering the real burden of debt. However, debt declined as a result of a sustained period of economic development and increased tax collections.
Economic Growth and Government Debt
Another concern is that if the government reflates the economy (for example, by pursuing quantitative easing), it may increase both economic activity and inflation. A higher GDP is a crucial component in the government’s ability to raise more tax money to pay off its debt.
Bondholders may be concerned about an economy that is expected to experience deflation and negative growth. Although deflation might increase the real value of bonds, they may be concerned that the economy is stagnating too much and that the government would struggle to satisfy its debt obligations.