Steve Bain

The Effects of Inflation Explained

The effects on inflation are seen in both the consumer goods market and in the financial assets market, but the effects on these two markets are regarded very differently.

When we think of asset price inflation, i.e. rising house price valuations or rising stock market investments, we usually regard this as a good thing since it increases our wealth. However, when the prices of consumer goods increase, like food, energy, clothes, cars and so on, we regard this as a bad thing since it increases the cost of living.

In reality, when prices rise because the economy is growing too quickly, at a rate that cannot be sustained, the effects of inflation will be a net negative even in the asset markets, because the high valuations there also cannot be sustained. 

Generally speaking, inflation causes:

  • Loss of Purchasing Power
  • Increased Inequality
  • Economic Instability
  • Slower Economic Growth
  • The Risk of Recession

Of course, the ravages of inflation will not fall equally on all members of society, and some people can make fortunes if they know when to buy and sell assets.

In this article I will explain how inflation hurts consumers and the economy in general. There are some controversies here with regard to low levels of inflation, so read on for details.

Effects of Inflation on Consumers

There is no controversy regarding the costs of inflation on consumers, and this is the simplest aspect to explain. When prices rise, consumers suffer a loss of purchasing power. The statistic that is most commonly quoted to reflect the changing cost of living is called the Consumer Price Index (CPI).

How does inflation affect a household?

The CPI does not reflect asset price increases, only consumer goods, so the effect of inflation on household budgets for monthly expenses is best measured by the CPI.

Increased inequality among households arises because some people have a larger proportion of their incomes coming from fixed return assets. Pensioners, for example, often receive a relatively fixed sum of money each month, and when the CPI rises it reduces the purchasing power of that income.

Other households are better equipped to handle rising prices. For example, some workers are better able to negotiate an increase in their salaries to compensate them for the extra cost of living. Additionally, those people with the largest debts (on fixed-interest repayments) will benefit from inflation, because it will erode that debt.

Paradoxically, it is the richest members of society who tend to have the most fixed-interest debt, and this is another reason why inflation increases inequality. 

Effects of Inflation on the Economy

The controversy that I mention in the opening section relates to low levels of inflation. Some economists, Keynesians in particular, believe that a low level of inflation is beneficial to an economy. Other economists, myself included, believe that this is nonsense.

However, the government and the Federal Reserve Bank are both aligned with the Keynesian viewpoint, and because of that the Fed favors a target rate for inflation at around 2% per year.

Positive Effects of Inflation (according to Keynesians)

The main potential benefit of a low, but significant, level of inflation relates to the way that some nominal prices in the economy can be sticky and resistant to supply & demand forces.

If, for example, an industry suffers from wage rates that are too high, it may be difficult to convince employees to accept lower pay. This might happen with a declining industry.

The UK coal mining industry is a good example, where mine workers at one time used to receive generous pay. Over time, domestic UK mines lost their competitive edge against cheaper imported coal, but there was fierce resistance from the National Union of Mineworkers to proposed pay cuts (and pit closures). In the end the UK coal mining industry collapsed, but not until a long and costly strike action was over.

This particular example was mired in a great deal of political rivalry, and is perhaps not the best example for that reason. However, it is possible that in some similar circumstances a nominal pay freeze might be more easily agreed, and that the effects of inflation could slowly bring down the real cost of labor to a more sustainable level.

However, the evidence that prices are sticky in any meaningful way is patchy at best, and it is a poor justification for inflation. For more information on that, have a look at my article about Sticky Wages and Prices.

Another controversial claim about the potential positive effects of inflation relates to the avoidance of deflation. Keynesians regard deflation as being far more damaging than inflation, and therefore feel that there is a safety cushion benefit from having some low level of inflation to guard against it.

The argument here is that falling prices threaten recession by deterring spending, because consumers will want to put off non-essential purchasing until a later date in order to obtain lower costs. However, if this is so then why do people rush to buy the latest smartphones and other tech devices? These items are always getting better and cheaper.

Similarly, if falling prices deter current consumption, then the implication is that it encourages saving. A higher saving rate in most of the Western economies is highly desirable, as it encourages more investment without the need to create excess credit to fund it. This is explained in more detail in my article about Full Reserve Banking.

Negative Effects of Inflation

The negative effects of inflation on the economy are proportional to the size of that inflation, with hyperinflation causing total devastation.  For more details on that refer to my article about Hyperinflation.

Recent research has started to point in the direction of even modest amounts of inflation as being detrimental to economic growth. In the work by Arthur Grimes (see PDF link below), it is estimated that an annual inflation rate of 9% will lead to a long-term decline in the economic growth rate of 1%.

Now, 9% inflation is not a low rate, but it is hardly hyperinflation either. Also, while a 1% reduction in annual GDP growth might seem trivial, the compounded effects of this over a decade or two are very significant. A 3% GDP growth rate over 20 years yields an overall GDP increase of over 80%. A 2% GDP growth rate yields less than a 50% increase.

Another problem arises with respect to the instability that inflation brings. Higher rates of inflation are also much more volatile, making it difficult for businesses to plan ahead. Business investment levels and long-term contractual agreements are much more difficult to plan when prices are volatile, and this can cause significant extra costs to manage it effectively.

In this regard, the impact of unanticipated inflation needs to be stressed. When inflation is anticipated well, it is easier to mitigate its effects. When it is unanticipated (as it will be when it is more volatile), it is harder to mitigate and will, therefore, cause more damage.

Ultimately, if left unchecked, it will become necessary for inflation to be brought under control via interest rate rises and spending cuts. If it is allowed to rise too far before action is taken to control it, the risk of recession will grow. I explore this more in my article 'Can Inflation Cause a Recession?'.

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