Economy Simplified: Meaning and Effects of Inflation


Inflation measures the average price change in a basket of commodities and services over time. Inflation refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc.
 Inflation is indicative of the decrease in the purchasing power of a unit of a country’s currency. 
Inflation occurs when spending on goods and services outstrips production. Prices can rise because of supply constraints that increase the cost of producing goods and offering services, or because consumers, enjoying the benefits of a booming economy, spend their excess cash faster than producers can increase production. Inflation is often the result of some combination of these two scenarios.

Effects of Inflation

  1. Erodes Purchasing Power: An overall rise in prices over time reduces the purchasing power of consumers, since a fixed amount of money will afford progressively less consumption.
  2. Hurts the Poor Disproportionately: Lower-income consumers tend to spend a higher proportion of their income overall and on necessities than those with higher incomes, and so have less of a cushion against the loss of purchasing power inherent in inflation. This is what economists mean when they note that lower incomes correlate with a higher marginal propensity to consume.
  3. When High, Feeds on Itself: But when the inflation rate sharply accelerates and stays high, expectations of future inflation will eventually begin to rise accordingly. As those expectations rise, workers start demanding larger wage increases and employers pass on those costs by raising prices on output, setting off a wage-price spiral.
  4. Raises Interest Rates: Governments and central banks have a powerful incentive to keep inflation in check. Policymakers can raise the minimum interest rate, driving borrowing costs across the economy higher by constraining money supply.
  5. Lowers Debt Service Costs: While new borrowers are likely to face higher interest rates when inflation rises, those with fixed-rate mortgages and other loans get the benefit of repaying these with inflated money, lowering their debt service costs after adjusting for inflation.
  6. Lifts Growth, Employment in the Short Term: In the short term, higher inflation can lead to faster economic growth. Elevated inflation discourages saving, since it erodes the purchasing power of the savings over time. That prospect can encourage consumers to spend and businesses to invest. As a result, unemployment often declines at first as inflation climbs. Historical observations of the inverse correlation between unemployment and inflation led to the development of the Phillips curve expressing the relationship. 
  7. Can Cause Painful Recessions: The trouble with the trade-off between inflation and unemployment, is that prolonged acceptance of higher inflation to protect jobs may cause inflation expectations to rise to the point where they set off an inflationary spiral of price hikes and pay increases, as happened in the U.S. during the stagflation of the 1970s. [Stagflation is the simultaneous appearance in an economy of slow growth, high unemployment, and rising prices]
  8. Hurts Bonds, Growth Stocks: Normally, bonds are lower-risk investments providing regular interest income at a fixed rate. Inflation, and especially high inflation, impairs the value of bonds by lowering the present value of that income.  Growth stocks, which tend to be more expensive, are notoriously allergic to inflation, which discounts the present value of their future cash flows more heavily, just as it does for high-duration bonds.
  9. Boosts Real Estate: Real estate has historically served as an inflation hedge, since landlords can protect themselves against inflation by raising rents, even as inflation erodes the real cost of fixed-rate mortgages.

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