What would you do if the money in your wallet or bank account could buy less and less every year? Would you spend more time thinking about how to get the most out of your money while you could? Would you change what you bought or how much? Would you keep money in your savings account?
Inflation affects everyone in the economy: workers, businesses, people on fixed incomes, lenders and borrowers. For example, consumers need to keep track of the prices of items they purchase. When inflation is high, they need to spend more time shopping, looking for the best deals. Companies need to think about how much to raise prices as it becomes costlier to produce their products. Individuals will also act to protect their financial assets from rising prices.
Inflation can also be very hard for people on fixed incomes. Inflation means their incomes won't stretch as far as they could before, and people will have to buy less. If inflation is moderate (prices are increasing by a little), they may have to cut back on non-necessities like travel, movies, or eating out. If inflation is high, they might have to cut back on necessities like utilities and food.
Another problem caused by inflation is that it is unpredictable-that is, we cannot perfectly know what inflation is going to be in the future. Interest rates reflect in part what inflation is expected to be over the life of a loan. So inflation that is higher or lower than expected can create "winners" and "losers" because it shifts purchasing power between savers and borrowers. If inflation is higher than expected, borrowers (debtors) win because they repay the loan with less valuable dollars. However, if inflation is lower than expected, savers (creditors) win because the loan repayment is worth more as it reflects more valuable dollars.
Want to keep reading? Learn why the Fed cares about inflation.