What are the Effects of Inflation on the Economy?

Understanding How Inflation Helps and Harms Investors and Consumers

What are the effects of inflation? The first is watching money become less valuable so that the purchasing power of each dollar, or pound sterling, or yen buys less goods than it did int he past. It is as if the purchasing power went up in smoke.
What are the effects of inflation? The first is watching money become less valuable so that the purchasing power of each dollar, or pound sterling, or yen buys less goods than it did int he past. It is as if the purchasing power went up in smoke. Steve Bronstein/Getty Images

What are the effects of inflation?  This common question is often asked by new investors embarking on their journey towards financial independence.  To ensure we are on the same page, before we dive into the inflation's effects, it is best to start by defining inflation in stark terms.  Properly used, and as I will employ it for the remainder of our discussion, the term inflation refers to the depreciation in purchasing power of a fiat currency, often resulting in the appearance of rising prices when you attempt to buy essentials such as wheat, milk, meat, clothing, medical services, coffee, or electricity.

 In other words, inflation refers to a situation in which you find that it takes more units of currency — if you are in the United States, it would be U.S. dollars — to buy goods and services than it took you yesterday or last year to buy the same goods and services.

Historically, for domestic investors, a high inflation rate has been considered anything over the 3% to 4% annual range with the 3% to 4% figure considered benign.  This rate, which would be a godsend for most of the world, is caused by numerous things, some of which have to do with certain monetary and structural advantages in the U.S. economy that may not last indefinitely.  That said, for the past decade, the country has experienced a historically low interest rate environment due to unprecedented intervention in the monetary system by the Federal Reserve and lawmakers as part of the efforts to stave off collapse of the global economic system back between 2007 and 2009 when the real estate bubble peaked and imploded, dragging down all sorts of asset classes with it, including the stock market.

Still, if history is any guide, it's useful to pay attention to inflation because it's bound to rear its head again at some point in the future.  What are the specific effects of inflation?  Why should you be concerned about its spectre haunting the economy?

Inflation Begins with Money Losing Value

To understand the effects of inflation, I want you to think about a few numbers:

  • A $1.00 bill in 1971 had the same purchasing power as $5.95 does in 2016. That is, what we call $1.00 today would only buy 16.8¢ worth of goods in 1971.
  • A £1.00 bill in 1971 had the same purchasing power as £14.00 does in 2016. That is, what we call £1.00 today would only buy £0.07 worth of goods in 1971.

As you can see, the major effect of inflation is that a nation's nominal currency loses value - it takes more Dollars, or Pounds Sterling, or Euros, or Yen, or Swiss Francs, to buy the same quantity of goods.  The obvious consequence, or effect, of this is that inflation makes it more difficult for people to afford the basic necessities, not to mention luxuries, of life if their labor is not able to keep pace with the inflation rate.  This causes families to struggle as they attempt to keep up with the price of everything from cornflakes to college tuition.  

As you can see, high rates of inflation can cause major problems as time progresses.

Inflation Transfers Money From Savers and Investors to Debtors

Moving beyond the basic effects of inflation, you come to realize there are two other major effects of inflation.

  1. The effect of inflation on savers and investors is that they lose purchasing power.  Whether you've buried your money in a coffee can in the backyard or it's sitting in the safest bank in the world, it is becoming less valuable with the passage of time.  This can create an incentive to spend money or, under the wrong conditions, a disincentive to invest money in things that would otherwise be good for civilization in the long-run.
  1. The effect of inflation on debtors is positive because debtors can pay their debts with money that is less valuable. If you owed $100,000 at 5% interest, but inflation suddenly spiked to 20% per year, you are effectively watching 15% of your debt get paid off each year, totally free to you.  At some point, you'd be able to get a minimum wage job for $100 per hour and obliterate your debt.

Put more bluntly, the net effect of inflation is that it serves to transfer money from savers and investors to debtors.  It punishes those who postponed their enjoyment and invested in building roads, schools, factories, and businesses and gives their reward to those who are in debt.  It is a severe moral injustice, mostly caused by governments printing money — or, these days, making electronic entries — to cover expenses that cannot be paid out of the general treasury revenue.

More Information About Inflation and the Inflation Rate

To learn more, read The New Investor's Guide to Inflation and the Inflation Rate, a special that answers questions such as: