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Is Inflation Always Bad for the Economy?

The term “inflation” can have varied meanings depending on context, but fundamentally it refers to an increase in the cost of goods and services. As consumers, we have a negative association with inflation because things are more expensive for us to purchase. But is inflation always bad for the economy? As a broader concept, inflation has pros and cons that affect everyone.

Pros of Inflation

Higher Short-term Profits

Large corporations and small business owners alike can benefit from higher prices by realizing increased profit. This is especially true in service-oriented industries where increased income less likely to be offset by higher business costs. Sustained inflation will impact production costs enough that the increased profit margin is likely eroded.

Increased Consumer Spending

As counter-intuitive as it may seem, steady, controlled inflation is often viewed as a condition that stimulates consumer spending. The idea here is that an environment of decreasing prices (or “deflation”) encourages consumers to hold onto their savings based on the belief that lower prices are on the way. Conversely, a general sense that something is more likely to cost more tomorrow than it does today leads to an increase in purchasing. This is particularly true for “big ticket” items like appliances, consumer electronics, home furnishings, and automobiles.

Higher Wages

This is advantage of inflation depends on the economic drivers at work, but when inflation is the result of increased consumer demand and low unemployment rates, companies are likely to respond by increasing wages to attract workers to make sure the company can continue to meet demand. This positive effect of inflation, however, can be short lived. A prolonged period of higher wages can feed a cycle of higher prices. The longer-term effect can be a decrease in “real wages” as shown in the charts below in the “con” section.

Better Savings Rates

A typical target inflation rate for central banks is around 2%. When inflation outpaces that rate, the central bank can respond by increasing interest rates as a way of cooling off consumer spending and decreasing demand, which in turn leads to downward pressure on prices. Higher interest rates are advantageous to savers who keep money in interest-bearing savings accounts and money market funds.

Debtor Benefits

When inflation is high, money is worth less. In other words, as the cost of goods rises, the purchasing power of your money decreases. For example, if a gallon of milk costs $2.50, you can buy 2 gallons with a $5 bill. If inflation causes the price of milk to rise to $5 a gallon, though, that same $5 bill is now half as valuable in terms of how much milk it can purchase. From the perspective of a debtor, if they borrowed $5 back when it was worth two gallons of milk, they can pay it back now when it is inherently worth less.

Cons of Inflation

Higher Cost of Borrowing

The same effect described above that increases interest rates and benefits savers has the opposite effect on borrowers. One of the disadvantages of inflation and higher interest rates is the increased cost to repay the interest on debt. For people who have variable interest rate debt (think credit cards) their monthly interest payment will be higher. This means that someone who is repaying debt with a fixed amount each month will see less of that payment go toward the principal balance and more of it toward the interest.

Savings are Worth Less

This is the inverse of the Debtor Benefits listed above. When the purchasing power, and therefore value, of money decreases, then the amount you have saved is inherently worth less. That $5 referenced above? If it has been sitting in your savings account or under your mattress, it can now buy less than it could have before inflation. This can be offset some if the savings are in an interest-bearing account (see Better Savings Rates above), but unless those interest rates are higher than the rate of inflation (and they usually aren’t), the real worth of your savings is decreasing as inflation grows.

Fewer Exports

When the cost of goods rises, it is not just the consumers at home who feel that impact. Consumers in other countries also have to pay more, and that makes them less likely buy them as imports. For the country with inflation, then, that means decreased exports, increased imports and a growing trade deficit.

Reduction in “Real Wages”

The chart below shows inflation-adjusted (or “real”) weekly wages (in 1982-84 dollars) for production and non-supervisory employees, generally regarded as “typical” workers:

Source: Bureau of Labor Statistics Data, U.S. Department of Labor

As the chart shows, weekly wages for U.S. workers peaked in the early 1970s, bottomed out in the mid 1990s, and have been recovering since. Another way to think about this is that one of the impacts of inflation over the past 50 years is that consumers today have slightly less buying power than they did in 1970, but more buying power than consumers in 1995. Now take a look at a similar chart showing the Consumer Price Index (CPI), or average price of goods, for the same period:

Source: Bureau of Labor Statistics Data, U.S. Department of Labor

Together, the graphs show that, the high wages of the early 1970s led to higher prices (inflation) in the late 70s and early 80s. These in turn decreased the value of real wages for much of the 1980s and 90s. The extended period of low CPI numbers since the mid 80s, however, has contributed to a steady increase in average weekly earnings. So, in summary, a disadvantage (or con) of inflation – as seen in the CPI – is the decrease in weekly earnings when adjusted for inflation.

Conclusion

The disadvantages of inflation are the ones we feel most immediately, but there are advantages as well. A healthy economy is all about balance, and a steady rate of inflation contributes to that balance. So, no, inflation is not always bad.

Recently, inflation has been consistently above the Fed’s target rate of 2%. How has inflation affected you? Are you enjoying the higher savings rates, or is that outweighed by the higher cost of goods?

Check out the other articles in the Finance category!

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