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15 Positive and Negative Effects of Inflation

August 12, 2022
6
min

Inflation can be beneficial for the economy but it can affect the value of savings, income investment returns, and can lead to decrease the competition for a country.

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Inflation is the rise in prices of goods and services over a period, which has both positive and negative effects for consumers and the economy. It occurs when prices of goods and services rise over a certain period, resulting in a fall in consumer buying power. The U.S. Bureau of Labor Statistics (BLS) measures the rise, which is typically conveyed as an annual percentage compared to the year prior. Some amount of inflation, around 2%, is good for the economy since it spurs spending. 

But in June 2022, inflation reached a near 41-year high, according to the BLS, which makes it more expensive for people to purchase the things they need to live. This spike in inflation was caused by many things: The COVID-19 pandemic, disruptions in the global supply chain, government stimulus checks, low interest rates, and later, the Russian invasion of Ukraine which led to sanctions on Russian fuel and shortages of Ukrainian exports like grain.

15 Effects of inflation

Economists use a variety of indices to measure inflation’s causes and effects. That includes the Consumer Price Index (CPI), which tracks the change in the prices of around 80,000 goods and services; the Wholesale Price Index (WPI), which measures the price of goods at the wholesale level before they reach consumers; and the Producer Price Index (PPI), which tracks the price of goods and services before they reach retail. Inflation has an effect on the overall economy as well as individual consumers. 

Effects of inflation on the economy

The government and the Federal Reserve (the Fed) try to keep inflation in balance because of the effects it has on the overall economy.

These are some of the positive effects of inflation on the economy:

1. Economic growth. More money in the economy can increase the overall demand for goods and services, leading to an increase in production and overall economic growth.

2. More consumer spending. Consumers often spend more in times of inflation, anticipating higher prices ahead. When people anticipate rises, they buy more today, which is one reason the Federal Reserve sets a target of 2% for inflation. When prices fall, during deflation, people may put off spending in the hopes that prices will drop further. This leads to a contraction of the economy. 

3. Higher wages. When prices rise, workers may demand bigger paychecks to keep up with the rising costs. Higher wages may, in turn, lead to more spending, which spurs the economy.

4. Assets increase in value. When inflation happens, the price of home construction rises and home prices generally increase. When this happens, homeowners benefit from the increased value.

5. Easier loan repayment. In an inflationary environment, those who owe debts can pay down loans with money that is worth less than the money they borrowed.

Some of the negative effects of inflation on the economy include:

6. Higher prices for basic goods. With inflation, it costs more to keep the same standard of living. If the value of a dollar drops, and wage increases don’t keep up with rising prices, consumers lose purchasing power. Consumers feel the pinch at the grocery store and at the pump. Overall, inflation rose 9.1% in the 12 months ended June 2022, according to the Bureau of Labor Statistics. The indexes for gasoline, food, and shelter all increased, and energy prices rose 41.6% from a year earlier. Consumers experienced the biggest price hikes in categories such as cereals and bakery products (13.8%) and dairy (13.5%). 

7. Savings depreciate. Those who live on fixed incomes, such as retired people, see the value of their savings depreciate when there is high inflation. (The Social Security Administration, however, does make cost of living adjustments to benefits.)

8. Lower global demand. A higher inflation rate can make a country’s exports more expensive. As a result, its trade partners may seek other sources for their goods.

9. Economic uncertainty. High inflation could lead to people cutting back on spending and investing, which has the opposite effect of mild inflation on economic expansion. This can result in deflation and a potential contraction of the overall economy.

10. Disproportionately affects lower-income people. Those who earn less spend a higher percentage of their income on necessities like food and gas, are therefore more affected by price rises in goods. They are also less likely to own assets, whose values increase during inflation.

Effects on investors 

When inflation begins to rise, the Fed often increases interest rates to make it more expensive to borrow money in an attempt to take some money out of circulation. In other words, inflation is usually followed by rising rates. 

Some investments, such as assets with fixed cash flows, lose value in this circumstance because they don’t increase their payouts to keep pace with inflation. But holding assets in which investors can raise fees on (such as raising rents on property they own) can benefit those investors. Here are five effects of inflation for investors.

11. Decline in the value of savings. Savings accounts can lose value if the rate of inflation outpaces the interest rate on the account. For instance, if a person has $200 in an account that pays a 1.5% interest rate, they will have $203 in their account at the end of the year. If inflation is at 6%, that person would need $212 to have the same buying power as at the beginning of the year.

12. Lower returns from bonds and other fixed income investments. Most bonds and other fixed income securities make fixed interest payments, which remain the same until maturity. That means that their value at maturity can be diminished if inflation rates rise above the interest rates they pay out.

13. Stock volatility. Inflation causes economic uncertainty and can cause volatility in the stock market. The price of stocks might be expected to rise along with the prices of consumer goods, since one might expect a company’s revenues to increase along with inflation. However, this is not always true, and the increase in volatility plus an erosion of investor confidence can take a toll on stock prices. 

14. Benefits real estate owners. Homeowners and property owners with fixed-rate mortgages can benefit from inflation because they are paying their mortgage payments with dollars that are worth less than those they borrowed. Homeowners who rent out their property can also increase rents during times of inflation—thereby profiting from it. In a climate of rising inflation and home prices, rents typically go up.

15. A rise in the value of commodities. During inflation, the demand for goods and services increases, and the price of the elements used to produce those goods also rises. Commodities, or consumer products such as wheat and corn, oil and gas, and cotton, usually perform well during inflation for this reason. Commodity-related equities are a way for investors to hedge against inflation.

The bottom line

The Fed considers a 2% inflation rate to be ideal for a steadily expanding economy. That’s because a bit of inflation encourages spending in anticipation of rising prices, which can lead to higher wages and growth in the economy. 

But inflation can also degrade the value of people’s savings, fixed income investment returns, and can lead to a decrease in global competition for a country. It also disproportionately affects lower income consumers, since they spend a higher percentage of their income on consumer necessities and are less likely to own homes.

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