Effects of Inflation

Effects of Inflation

Effects of Inflation

Inflation is not a new phenomenon. It has been well studied throughout the years, with its effects widely researched. Which is why the Central Banks try to aim and keep its rate at around 2 percent. This is because too much inflation can lead to hyperinflation as seen in the Weimar Republic, or Venezuela of today. While inflation can help stimulate economic activity, too much can destroy it.

We will look at the main effects of inflation below, but it is important to note that these effects will depend on the rate of inflation. For instance, a rate of 2 percent will not have the same effect as a rate of 100 percent a year. Therefore, we will look at the effects that primarily occur from prolonged and sustained levels of inflation that occur above 2 percent.

Key Points
  1. One of the most crucial effects of inflation is the loss of purchasing power.
  2. Those who have savings tend to lose to inflation, whilst those with debts generally benefit.
  3. Whilst the effects of inflation are seen as largely negative, there are some positives. For instance, it can help reduce the debt burden for private households and governments.

Negative Effects of Inflation

1. Money Loses its Value

As the prices of products go up, money loses value. For instance, if you keep $1 under your pillow for ten years, you will not be able to buy as much as you could today due to inflation.

If we look at the value of the US dollar between 1980 and 2019, we can see that the dollar has lost over half its value. In other words, you can buy half as many goods and services with one dollar as you could 30 years ago. So if you stored $1,000 under your bed in 1980, it would be worth less than $500 today.

Effects of Inflation - reduced purchasing power

As a result of the loss of purchasing power, inflation causes consumers to try and find a return on their capital. Rather than leaving money under the mattress, or in low-interest bank accounts, it incentivizes consumers to find better returns. This is because consumers fear that the money they have saved over the years will gradually become worthless.

At the same time, inflation creates a greater pressure on businesses to invest any excess capital. So any money that is not being used is losing its value if it’s not employed in some fashion. Whether this is in the stock market, or another form of investment.

2. Inequality

Inflation can predominantly hurt low-income households. They spend by far the largest percentage of their income, so price increases usually take up more of their incomes. For instance, when the price of necessities such as food and housing goes up, the poor have no choice but to pay. An increase of $10 a week in the price of food has a more profound impact on someone earning $12,000 a year than someone on $50,000.

One of the effects of inflation is that asset prices tend to rise. Assets such as housing, the stock market, and commodities such as gold tend to outstrip inflation.

This increases inequality as richer households have more assets. They own more property, shares, and other assets. What this means is that when inflation occurs, these assets increase in price ahead of ordinary goods such as bread, milk, eggs, etc. As a consequence, they end up with wealth that can buy them more goods and services than previously. At the same time, low-income households are having to spend more just to get by.

Those on lower incomes tend to spend a higher proportion of their incomes, hence they have less to save and invest in stocks, bonds, and other assets. Furthermore, they are equally unlikely to be able to afford to invest in high capital expenditures such as a house. What results is that those who are able to invest some of their incomes into ‘inflation protected’ assets such as stocks are left better off in comparison.

3. Exchange Rate Fluctuations

Increase in Money Supply

When the money supply and prices increase, a countries currency can decline in value. For example, if $1 million is in circulation in the US and YEN30 million in China, this may suggest an exchange rate of 1:30. However, if the Federal Reserve creates a further $1 million, taking the total to $2 million, then the ratio will decline to 1:15. This is just suggestive, as the exchange markets fluctuate daily. However, the premise remains the same. When prices inflate and the money supply expands, its value against other currencies decreases.

Let us take another example. A Chinese vase is worth YEN 100. This is traded with the US for a barrel of American oil worth $25. Based on this exchange, there would be an exchange rate of 1:4. However, the Chinese print more money and inflation increases the price of the vase to YEN 200.

The value of the vase to the US has not gone up. So they would not be willing to suddenly exchange two barrels of oil for the same vase. What happens as a result is the exchange rate adapts to the new reality. With the American oil worth $25, and the Chinese vase now worth YEN 200, this would take the exchange rate up to 1:8.

US Index Comparison between Inflation and the Weighted Exchange Rate
Effect of Inflation - exchange rate fluctuations
Exchange Rate Decline Causes Inflation

As we can see from the chart above, there is a relative correlation between inflation and the exchange rate. However, that does not necessarily mean that inflation causes the exchange rate to fluctuate. Often, inflation can result from other factors that contribute to exchange rate fluctuations. In other words, a fall in the exchange rate causes inflation rather than the other way around.

Although an increase in the money supply can create inflation and cause the exchange rate to fall, a decline in the exchange rate can create cost-push inflation. Simply, this is where the price of imported goods increases as the domestic currency can buy fewer goods. This may be a result of having a trade deficit, poor economic performance, or high-interest rates.

4. Impact on the Cost of Borrowing

If you take out a mortgage for $200,000, you have to pay that much back, plus interest. That loan may be over 25 years, with an interest rate of 5 percent. The total cost of over 25 years will be over $345,000. That’s over $145,000 in interest costs alone.

However, when we consider inflation from the past 25 years (1995-2020), the real cost is $205,000. In other words, in 2020 prices, the total cost of $345,000 is equal to $205,000 in 1995 prices. So although we are looking at an extortionate amount of money to repay, inflation is able to reduce the cost.

If we put it another way, the initial money that is borrowed is worth less year on year. So the debtor needs to provide fewer resources in order to pay their debt. For instance, a debtor may earn $20,000 per year after tax. They also take out a loan for $40,000, which is the equivalent of 2 years of wages. However, after 5 years, inflation has taken their wages to $40,000, which is now equivalent to 1 years wage.

With that said, consistent and high levels of inflation may prompt financial institutions to increase their rates in order to protect themselves from inflationary pressures. In turn, debtors may actually find it harder to obtain credit.

5. Increased Cost of Living

As prices of goods increase, it goes without saying that consumers will have to pay more in order to buy basic necessities and luxuries alike. This may not necessarily be a problem if incomes rise in line with inflation, but those who don’t will face higher real prices. In other words, they will have to spend a higher percentage of their income on the same number of goods.

What inflation also does is push tax-payers up into higher tax brackets, meaning higher taxes for some. If the brackets aren’t adequately adjusted to the new reality, they end up worse off as a result.

Low skilled workers are also particularly affected as their wages are particularly sticky due to the high level of competition in the market. There are many low skilled workers vying for employment, meaning the employers have great power. In turn, wages can lag behind the rest of the economy, making them even worse off. On top of that, minimum wage rises do not always follow inflation, which also puts further downwards pressure on wages.

Positive Effects of Inflation

1. Increased Spending and Investment

As inflation increases, consumers are incentivized to move purchasing decisions forward. Rather than wait until next year when the product will be more expensive, consumers rationally elect to buy now than pay more next year.

For the average consumer, this means buying new cars, fridges, phones, and other consumer goods. Yet this extends beyond consumer goods. Consumers are also incentivized to find the best return on investment. As money starts losing its value under inflation, it is necessary to ‘beat’ it just in order to maintain the same purchasing power.

For instance, a consumer may have $1,000 in the bank, but is only earning interest of 1 percent. However, if inflation is consistently at 3 percent, they are losing money year on year. In turn, they can then react in two ways.

First of all, let inflation take hold and see the value of their money decline. Or, second of all, try and find higher-yielding investments. This can be positive for the economy as savers are looking to move their money to areas of the economy which will be most productive.

However, this presents a risk as the average consumer may not have the requisite knowledge or skill to make a good investment. In turn, there is a greater risk of economic loss due to poor money management.

2. Higher Asset Prices

Historically, asset prices increase more rapidly than inflation. For example, long-term house prices have historically out-stripped inflation. An average house sold in the US was $74,500 in 1980, which, adjusted for inflation is worth $231,000 in 2019 prices. By comparison, the average house sells for $375,000 in 2019; a massive $144,000 in real gains over 39 years.

The stock market is also a prime example. Since the inception of the S&P 500 in 1926, it has returned an average return of 10 percent per year. Once we account for inflation, it returns a rate of over 7 percent above inflation.

What happens during consistent inflationary periods is that consumers and businesses move purchasing decisions forward and spend more rapidly. Or, they move their capital into illiquid assets such as stocks, bonds, and real estate. What happens, in reality, is a mixture of both.

So a consistent inflationary environment is caused by higher levels of spending as consumers moving purchasing decisions forward. At the same time, we also see increasing asset prices as a result of individuals moving investments to illiquid assets which can better protect against the eroding effects of inflation.

3. Reduces Effective Level of Debt

Whether it’s a business, the government, or the consumer, those who have high levels of debt may in fact benefit from having higher levels of inflation. For example, the borrower may have an interest rate of 2 percent on their debt. If inflation is at 10 percent, and their income increases at a similar rate, it means the effective rate by which they are repaying declines.

Although this can be a positive effect of inflation for those in debt, but for individuals such as savers and institutions such as banks, it can actually be a huge disadvantage. Banks lose out because they are receiving lower levels of interest than the rate of inflation. And for savers, they are likely to be earning interest below the rate of inflation.

4. It’s better than Deflation

Many economists argue over what is the most optimal rate of inflation – 1 percent, 2 percent, or 4 percent? However, there is a general consensus that whatever it is, it’s generally better than deflation.

Deflation is perhaps more harmful to an economy than inflation. It has the potential to increase the debt burden to both governments and private businesses/individuals. This can effectively paralyse public services and create a huge number of bankruptcies as firms are unable to meet repayments which are effectively becoming more expensive.

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