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.
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What are the effects of inflation? This common question is often asked by new investors embarking on their journey towards financial independence. Before taking a deep dive into inflation's effects, it is best to start by understanding inflation in stark terms. Especially for those new to the world of economics, the issue of understanding inflation (and how it affects your daily life) can be confusing.

When used properly, 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.

What Is a High Inflation Rate?

Historically, for domestic investors, a high inflation rate has been considered anything over the 3 percent to 4 percent annual range with the 3 percent to 4 percent figure considered benign. This rate, which would be a godsend for most of the world, is caused by a number of things. Some of these things 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 the collapse of the global economic system.

The system was in jeopardy back in 2007, 2008, and 2009 when the real estate bubble imploded—dragging down all sorts of asset classes with it, including the stock market.

If history is any guide, it's useful to pay attention to inflation because it's bound to rear its head again in the future. What are the specific effects of inflation? Why should you be concerned about its specter haunting the economy? Because inflation affects everything.

Inflation Begins With Money Losing Value

To understand the effects of inflation, consider the following example of the purchasing power of $100 in 1971, compared to today.

  • According to the Bureau of Labor Statistics consumer price index, prices in 2018 are 504.4 percent higher than prices in 1971.
  • In other words, $100 in 1971 is equivalent in purchasing power to $604.41 today.

The obvious consequence of inflation is that it makes it more difficult for people to afford the basic necessities (like batteries and light bulbs). This causes families to struggle as they attempt to keep up with the price of everything from cornflakes to college tuition. 

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.
  2. The effect of inflation on debtors is positive because debtors can pay their debts with money that is less valuable. For example, if you owed $100,000 at 5 percent interest, but inflation suddenly spiked to 20 percent per year, you are effectively watching 15 percent of your debt get paid off each year—and that's totally free to you. At some point, you would be able to get a minimum wage job for $100 per hour and be able to obliterate your debt.

    The Bad News Bottomline

    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 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 About Inflation and the Inflation Rate

    If you're still asking yourself "What Is Inflation?", What Is an Inflation Index?, or, perhaps, What Causes a High Rate of Inflation?, take a deep dive into The New Investor's Guide to Inflation and the Inflation Rate—it will help answer any other questions you may have.