When inflation increases, the purchasing power of a currency depreciates, resulting in rising prices for all goods and services. Fluctuating inflation rates affect all stakeholders in an economy including consumers, investors, corporations, and governments.
In this article, we'll discuss what inflation is and its effect on the economy. You'll learn about the impact of high inflation as well as the impact of low inflation. To wrap things up, the final section will go over expected vs. unexpected inflation.
What Is Inflation?
Inflation refers to the depreciation in purchasing power of a currency, often resulting in the appearance of rising prices when you attempt to buy things. In other words, inflation refers to a situation in which 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 yesterday or last year to buy the same goods and services.
To understand the effects of inflation, consider the following example of the purchasing power of $100 in 1971, as compared to today.
- According to the Bureau of Labor Statistics consumer price index, prices in 2021 are more than 557% higher than prices in 1971.
- In other words, $100 in 1971 is equivalent in purchasing power to about $657 today.
Historically, for domestic investors, a high inflation rate has been considered anything over the 3% to 4% annual range. This rate is caused by 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.
The Effects of High Inflation
The obvious consequence of high inflation is that it makes it more difficult for people to afford 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.
Moving beyond the basic effects of inflation, there are two other major effects of inflation.
- Loss of purchasing power: 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.
- Impact to payers and recipients of fixed amounts: 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% interest, but inflation suddenly spiked to 20% per year, you are effectively watching 15% of your debt get paid off each year.
Both of these can interfere with the many mechanisms in the economy. A loss in purchasing power may lead to decreased spending by the consumer. If consumers spend less, companies will suffer from a loss of revenue. Additionally, companies may suffer as the costs of goods and services needed to run their business increase. When that increases, they are put in the position of needing to raise their prices. If their revenue has already taken a hit from decreased spending, raising prices would only worsen the problem. If companies struggle, they will cut wages and/or the number of people they employ. As a result, unemployment can rise.
The Effects of Low Inflation
With many negative effects resulting from high inflation, that doesn't automatically mean that low inflation is positive for an economy. Low inflation can have a number of negative effects on the economy.
- Signals economic weakness: A lack of inflation may be caused by a lack of demand for goods and services. When demand is lacking, there is no pressure for prices to increase. Soft demand can slow growth and depress wages, which further exacerbates the impact of low inflation. This can result in a dangerous economic feedback loop.
- Limits impact of monetary policy: During an economic downturn or slowdown, one of the levers the central bank pulls to jumpstart the economy is lowering rates through monetary policy. If inflation is low, rates are likely to already be low. If rates are low, the central bank is unable to make a large impact through rate reduction.
- Buffer for deflation is small: When inflation is low, that means it's not only closer to zero, but it's closer to going negative as well. Inflation that goes negative is called deflation and deflation is a state no economy wants to be in. Deflation results in low consumer confidence and falling demand, prices, wages, and more.
- Puts pressure on the financial system: A functioning financial system is the backbone of a functioning economy. Imagine you are a bank and make your money on the spread between the costs of borrowing and the income from lending money out. When inflation is low, that spread decreases, which means the margin of profit decreases, possibly even going negative. When this happens, money can tighten up as lenders become more apprehensive to lend.
Expected vs. Unexpected Inflation
Inflation can be broken down into two components: expected and unexpected inflation. Expected inflation is simply the inflation that is expected from economic agents. Since they are anticipated, the expectation is embedded into economic decisions. For example, if inflation is expected to be 3% for the upcoming year, a restaurant owner may want to increase menu prices to account for the change. Otherwise, the real value of their revenue would decline.
Unexpected inflation is the inflation that economic agents haven't predicted.
Inflation that is lower or higher than what was expected can strongly affect the economy and cause volatility.
When inflation comes out different than predicted, there will be winners and there will be losers.
To illustrate, imagine that inflation came in higher than expected. Borrowers will come out winners and lenders will come out as losers. If a borrower is owed $1,000 a month and inflation occurs, the $1,000 payment they receive each month will be worth less and less as inflation climbs.
This is a single simple example, but seismic effects can happen if this played out across an entire economy.
The Bottom Line
Inflation is an important force that can dictate the performance and stability of an economy. Too much inflation, too little inflation, or a negative inflation value can harm an economy. In order for economies to move forward in a stable manner, slow and steady are desirable characteristics for inflation to show.