Consequences of Inflation

Consequences of inflation on the economy

To understand the consequences of inflation on the economy, we first must understand what is meant by inflation and economy, respectively. Inflation is the general increase in prices. The Economy is about managing the resources available to a country. Now that we have our foundation, we can begin to answer the question: how does a general increase in prices affect the management of resources?

If prices increase without a proportionate increase in income, reduced purchasing power will occur. This means that the value of the dollar is falling and unable to purchase the same number of goods as it once was able to. If the dollar is purchasing fewer goods than it once was, spending patterns will also change. What was once a cyclical purchase for an individual may have to be cut out of their budget due to increased prices.

These effects can make an economy, or the managing of resources, unstable. The production and consumption of goods will become discordant, resulting in resources becoming scarce or overabundant.

A Dollar Burning, pixabay

Consequences of inflation on the government

Let's go over the consequences of inflation on the government. A government will not be hurt by a small amount of inflation; in fact, central banks aim for around 2% inflation each year. This can be a sign of a growing economy! But uncontrolled and rapidly increasing inflation is dangerous for a government — this is known as hyperinflation.

A government will be heavily impacted by hyperinflation. For example:

Hyperinflation alone can break down a government, but losing the financial trust of other governments will worsen the situation.

Consequences of inflation for consumers

Let's go over the consequences of inflation on consumers. Increasing prices can have positive or negative effects depending on a few factors. A consumer's income level and whether they are borrowing or lending money will determine if inflation is affecting consumers positively or negatively. Let's go over both factors to see their effects.

Consequences of inflation for consumers: level of income

If a consumer has a low level of income, how might inflation affect them? Increasing prices will be exceptionally hard to deal with if a consumer has a low level of income. If prices continue to increase as incomes stay the same, consumers will not be able to purchase the same number of goods that they once were able to. Consumers' grocery lists, living situations, and bills will be compromised. This is a result of increasing prices outpacing consumers' low-income levels — reduced purchasing power.

If a consumer has a high level of income, how might inflation affect them? Increasing prices are still going to negatively impact high-income earning consumers, but not as severely as low-income earning consumers. High-income earning consumers can "absorb" the increasing prices because of their higher incomes. They will still pay more overall due to increasing prices, but they will not be hurt as much as low-income earning consumers. Their purchasing power is also reduced, but it is not as deleterious as it would be for low-income earning consumers.

Consequences of inflation for consumers: borrowers vs lenders

If a consumer is borrowing or lending money, are they both affected in the same way by inflation? No. In fact, one benefits while the other loses. A borrower will benefit from inflation since inflation devalues the dollar overall, resulting in less money owed to the lender. Let's look at a quick example.

Originally $50 was equal in value to a video game, however, after inflation, it is worth less than a video game. So when you pay it back, you are paying back less value according to its purchasing power even though it's the same $50.A lender will be hurt by inflation since the money they are paid back will be lower in value. Let's look at a quick example.

Figure 1. U.S. Consumer Price Index for the month of May, StudySmarter Originals. Source: U.S. Bureau of Labor Statistics²

The figure above shows the consumer price index for the month of May. As you can see, the price for consumer goods shot up tremendously in 2022! Consumers will definitely be affected as a result of this inflation. How they get impacted is heavily contingent on income level.

Consequences of inflation for producers

Let's go over the consequences of inflation for producers. It all links back to consumer behavior. If consumers are not buying as many goods as they once were due to increasing prices, how might that affect producers?

The negative effects of inflation for producers come from the decisions they have to make: increase or decrease prices due to inflation. Producers have two options: sell to those who can afford the goods at a higher price, or lower their prices to make their products cheaper. What are the results of both decisions?

If producers sell their goods only to higher-income consumers, then they miss out on many consumers who can't purchase their products due to inflation. However, producers may increase their profits if they increase their prices — it's a risky decision either way.

If producers lower their prices to make their products cheaper, producers risk shortages of goods since their products are relatively cheaper than other products on the market. Producers acting altruistically risk lowering their profits as a result of decreasing prices.

Consequences of deflation

Before going over the consequences of deflation, let's define deflation: the decrease in the price of goods. You may think that a decrease in the price of goods is a great thing! Maybe now you can buy a car or afford a mortgage. This does sound great, but what are the larger impacts of the price of goods falling?

Let's say you want to buy a new laptop and you know the price will go down next month. Will you buy it now or later? Probably later to save money. This concept also applies to deflation — a decrease in the price of goods will make people hold off on purchasing items. This can be bad for an economy since there's minimal activity in the market. Consumers are not buying, producers are not making, and the whole economy becomes stagnant. To keep an economy growing, a small amount of inflation is desired!